EssaysVolume3
The Collected Essays of
Richard A. Stanford
Essays on Money in the Global Environment
Richard A. Stanford
Professor of Economics, Emeritus
Furman University
Greenville, SC 29613
Copyright 2022 by Richard A. Stanford
Essays on Money in the Global Environment
NOTE: You may click on the symbol <> at the end of any section to return to the CONTENTS.
I. Money in Banking
1. Concepts of Money in Banking2. The Emergence of Commercial Banking
3. Lessons from American Banking History
4. Peculiarities of the U.S. Banking System
5. The First U.S. "Central Banks"
6. Constraints on Money Creation
7. The Desired Reserve Ratio
8. The Money Supply Process
II. Money in the Macroeconomy
9. Financial Markets and Instruments10. Determining Interest Rates
11. The "Realness" of Interest
12. The Implementation of Monetary Policy
13. Government's Potential for Stabilizing the Economy
III. Money in the Global Environment
14. Exchange Rates and the Demand for Money15. Weak and Strong Currencies
16. Payments Imbalances and the Money Supply
17. Exchange Rates and Global Macroeconomic Adjustment
18. The Dollar in the Post-War Era
19. The U.S. Central Bank in an Open Economy World
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I. Money in Banking
Until about two centuries ago, virtually all of the monies in use in the world were commodity monies, mostly gold and silver. The quantities of each were severely limited to the metallic substances that could be dug from the ground, refined, and not otherwise used for non-monetary purposes. During the commodity money era, fortuitous discoveries of precious metals led to gold or silver "rushes" that intermittently destabilized their economies due to uncontrolled growth of the money supplies. Another problem that appeared toward the end of the commodity money era, and which in fact was instrumental in precipitating the transition to the next era, was that in a growing world economy with increasing demands of commerce for expanding mediums of exchange, the commodity money stocks could not grow fast enough. A Fractional Reserve System (a) requiring the bank to alter its lending criteria; Economists conventionally identify four “factors of production”, land, labor, capital, and entrepreneurship, and the so-called returns to them, respectively, rent, wage, interest, and profit. Since interest is the return to real capital (real productive capacity, e.g., plant, equipment, housing), the interest rate in any region is a measure of the scarcity of capital in the region relative to the demand for it. This “true” (or scarcity) interest rate is higher in regions where capital is scarce and lower in regions where capital is more abundant. Interest rates typically are lower in capital-abundant developed regions of the world and higher in capital-scarce third-world countries. The true interest rate should fall as capital becomes more abundant. It would rise if capital were to become scarcer, e.g., when equipment is destroyed by a natural disaster or if gross investment in the region should become less than depreciation so that the capital stock actually shrinks. Interest may be construed as the return to financial instruments other than money. Figures 1 and 12 illustrate the determination of the interest rate by the interaction of the forces of demand for and supply of money. The demand for money is hypothesized to be an inverse function of the interest rate due to the opportunity cost of income from financial instruments not held in order to hold money which yields little or no interest. The supply of money is usually represented as perfectly inelastic with respect to the interest rate, and is presumed to be determined by the central bank of the region. In reality, commercial bankers and borrowers play some role so as to render the money supply a direct (though still highly inelastic) function of the interest rate. A decrease of either the price level or the real income level would cause the demand for money to decrease from D1 to D3 in Figure 1. There is now more money in circulation than people want to hold as represented by line segment AF. This puts downward pressure on the interest rate to fall from i1 to i3. The new equilibrium is at point E. At the lower interest rate, people are pleased to hold the amount of money in circulation, M1. A tighter monetary policy (implemented by open market purchases of bonds by the central bank) is illustrated in Figure 2 by the decrease of the money supply from S1 to S3. At interest rate i1, there is now less money in circulation than people wish to hold in the amount represented by line segment AF. This induces the interest rate to rise to i3. The new equilibrium is at point E. At the higher interest rate, people are pleased to hold the amount of money in circulation, M1. The yield rates or rates of return on financial instruments, euphemistically designated as “bonds,” vary inversely with the prices of those instruments. The bond yield rates are implicitly the interest rates on the bonds. Although there are numerous formulas for computing yields on bonds given their prices, examples using the "effective yield" formula reveal most simply the inverse relationship between the price of a bond and its yield rate: The Bond Market and the Money Market. This last relationship provides the needed explanation in the money market for why the interest rate changes when the demand or supply of money changes. In Figure 1, line segment AF represents an excess supply of money relative to the amount which people want to hold after the demand for money decreases to D3. In attempting to rid themselves of their excess money balances, they can purchase goods and services in those markets, or they can purchase financial instruments in the bond market. To the extent that they do the latter, the demand for bonds increases in Figure 3, pushing bond prices higher and yield rates lower. This is why the interest rate in Figure 1 falls from i1 to i3 when the demand for money increases. A similar explanation of the interest rate decrease in Figure 2 follows upon the illustrated increase in the supply of money to M2. In a financial sense, interest may be defined as the price for the use of a dollar’s (or other local currency unit's) worth of credit for a year. The issuance or sale of a financial instrument by a business firm or a government agency is an implicit demand for credit. The prices of financial instruments are determined by the interaction between forces of demand for and supply of bonds in the loanable funds market. Yield rates on bonds, understood to be their interest rates, are computed from information about the bond prices. In Figure 6, if the supply of loanable funds should increase from S1 to S2, the nominal interest rate would fall from i1 to i2. A decrease in the supply of loanable funds from S1 to S3 would induce the nominal interest rate to rise from i1 to i3. The so-called “real interest rate” on a financial instrument, r, may be computed as the nominal (market determined) interest rate, i, minus an allowance for the expected rate of inflation over the term of the instrument, %?Pe, Inflation is only one type of risk that may threaten lenders. Political risks include the possibility of tax rate or base changes, expropriation of capital assets, or even repudiation of debts. Natural disasters may threaten the physical structures of capital assets or the earnings flowing from the capital assets. Economic risks include advances in technology which render capital assets obsolete, shifts in the structure of demand, and adverse exchange rate variation. Risk premiums may be added to the nominal interest rate to compensate for any of type of risk. Nominal interest rates in any region are likely to rise with increasing risks, and to fall when risks diminish. Finally, the media (print, audio, video) and a few economics textbooks foster the notion that the central bank of the region determines interest rates and causes them to change as the vehicle for implementing monetary policy. This is of course a fiction, although a convenient one for reporting the actions of the central bank and assessing its monetary policy intent. A central bank wishing to implement a “tight” monetary policy may make public announcement that it is raising some interest rate, e.g., the Federal Funds rate, by some percent (usually expressed as a number of basis points, e.g., 50 for a half-percent change). What it is in fact doing is announcing a new rate target. Which of these seven theories seems to be true or useful? Can they be integrated into a coherent whole? The baseline for determination of the level of the interest rate has to be the scarcity of real capital, but the vehicle for establishing the scarcity of real capital appears to be the loanable funds market. Indeed, the loanable funds theory appears to be the most comprehensive and useful model of interest rate determination. Interest is often described as a payment for the use of borrowed funds. The interest rate is the cost of borrowing funds as a percentage of the amount borrowed. These are purely financial definitions of interest and the interest rate. What is missing in this specification is that interest is a real phenomenon attributable to the ability of real (rather than financial) capital to increase human productivity.
Macroeconomic Instability These demand-supply principles allow the following generalizations about the likely direction of change of an exchange rate. Each statement should be read through twice, once with the word to the left of the slash in each pair, and a second time with the word to the right of the slash in each pair. Careful attention should be paid to the ceteris paribus conditions. If "other things" do not remain the same, the conclusion of the generalization may not obtain. Scenarios Resulting in Current Account Deficits
Physical properties of money include portability, divisibility, durability, and general acceptability, but only the last in this list is both necessary and sufficient in order for something to serve as a medium of exchange. The other three properties are completely incidental to the service of something as a medium of exchange, and actually are possible properties of near monies."
It is not uncommon to suggest that savings may be invested in savings accounts, money market mutual funds, or various forms of bonds or stocks. This is a financial usage of the term "invest," but it is inappropriate language for students of economics. These activities are actually acts of portfolio choice rather than real investment. Real economic investment is the acquisition of productive capital, e.g., plant, equipment, rolling stock, or data processing and communications devices.
One's net wealth includes the stock of assets one owns, less his or her debts. For an individual it is alright to intermix examples of physical wealth (real estate, cars, textbooks) and financial wealth (stocks, bonds, cash on hand, money deposited in banks or other financial institutions) since the individual is a microeconomic entity. Individuals in making portfolio choices may hold some of their wealth in physical forms and the rest in financial forms. But if one were totaling up the wealth of a nation, (a macroeconomic aggregate), it would be quite inappropriate to include both financial and physical wealth types in the total because this would constitute double counting. From a macroeconomic perspective, financial wealth only enables access to real physical wealth.
A check per se is not money; it is only an accounting memorandum which can invoke bookkeeping entries, thereby transferring the ownership of money balances. An automatic teller machine (ATM) card (actually, a "debit" card) can be used to make purchases at many commercial establishments, but this fact does not make an ATM card money any more-so than a check is money. The ATM card is only a device which, like a check, invokes bookkeeping entries which effect a transfer of ownership of money. The money balances so transferred exist in the form of accounting balances on the ledgers of commercial banks.
A relatively new device called a "smart card" (also "e-money") contains embedded within it a microchip which can carry a money balance in (or on) the card itself. Thus, it would not be incorrect to say that a smart card is a certain amount of money since it can carry a money balance which can be used to purchase things.
Banks don't earn profit directly by receiving interest income on their customer loans; the interest income becomes part of the bank's gross revenues. A bank's profitability turns upon whether its total revenues exceed its operating costs during particular accounting periods.
Over the past two centuries, monies have undergone a momentous transformation so that today there is very little commodity money still in use anywhere in the world. Now, virtually all modern monies are debt (or credit) monies in the forms of token coins, promise-to-pay paper currencies (which are liabilities of governments), and checkable deposits (which are liabilities of commercial banks). The reason that this has been such a momentous transformation is that now there is technically no limit on the amounts of such debt monies that can be brought into existence by governments and central banks. This momentous transformation came about through a sequence of innovations.
Innovations usually identified in the emergence of commercial banking include the depository operations of metal smiths, written orders to pay, bank notes, the recognition that depositors typically withdraw only a small fraction of the valuables (i.e., gold) which they have on deposit, the possibility of lending gold while it is on deposit, and ultimately the possibility of lending a multiple amount of the deposited gold as long as borrowers make payments to parties, all of whom redeposit the borrowed gold back in the same bank.
Two other innovations that might be noted are warehouse receipts (e.g., gold and silver certificates) for the total values of the deposits and the possibility of multiple warehouse receipts in conventional denominations for the total value of any deposit. The concept of "warehouse receipt" may then be distinguished from that of "bank note." The warehouse (or deposit) receipt represents a particular amount of precious metal deposited; the bank note is a pure "promise to pay" liability of the bank which is redeemable in a specified amount of the precious metal, but not an amount which was deposited. Eventually, warehouse receipts in the form of gold and silver certificates were demonetized in the United States, only to be replaced by pure "promise to pay" bank notes which are not redeemable in any amount of precious metal and not even backed by any amount of precious metal.
Yet another innovation can be discerned in the progression of what became eligible for banks to lend: first only the deposited commodity money or specie (i.e., the bank's reserves), then warehouse (or deposit) receipts for the commodity reserves, then bank notes as pure promises to pay (not connected to any particular commodity on deposit but perhaps limited as a multiple of it), and finally additions to demand deposit balances (perhaps also limited in quantity by a required or conventional reserve ratio). The latter are created by the commercial bank when it exchanges a claim against itself (an addition to the borrowers demand deposit balance) for a claim against the borrower (a promissory note). The latter is not money but the former is by virtue of its general acceptability.
Following is a rough sequence of the events of discovery and innovation which occurred in the emergence of money and banking:
The American banking system is a fractional reserve banking system in the sense that commercial bankers desire to maintain reserves in the form of very liquid assets against their deposit liabilities. But they have learned with much experience that the reserves need to be only a very small proportion of the outstanding deposit liabilities--hence fractional reserves. It is also true that the central bank of the American economy requires commercial banks to maintain satisfactory amounts of reserves which are a fraction of deposit liabilities. But as a matter of prudence commercial bankers would do so anyway, and normally hold more reserves for safety than they are legally required to hold. They have incentive to minimize their holdings of reserves, because reserves themselves yield no income. Banking income is earned by holding assets in the form of customer loans or open market assets such as bonds. Deposit money is created as a by-product of extending customer loans.
An Historical Outline of American Commercial and Central Banking
Banking during colonial times: banking is primitive at best; a few English-owned banking companies serve depository functions in colonies; only money in use is English or Spanish.
1776, American Revolution, after which a few gold or silver smiths begin to operate as depositories on their own authority (not chartered by any official agency).
1791, (First) Bank of United States chartered by act of Congress to assist with finance of Revolutionary War debts; 20 year charter expires in 1811, just before War of 1812.
1800, perhaps 300 or so private banks have been chartered by new state governments.
1816, Second Bank of United States chartered by Congress to assist government with financing of 1812 War debts; 20 year charter to expire in 1836.
1820s and '30s, era of "free banking" as states chartered new banks at rapid pace with no controls; eventually over 3000 banks chartered in the 13 states formed from the original colonies, each bank issuing as many as half dozen denominations of currency; "wildcat banking"; counterfeiting; no other Federally chartered banks.
1832, Andrew Jackson elected President on promise of not renewing charter of Second Bank; Jackson feared and hated banking interests because a bank had foreclosed the mortgage on his father's farm.
1836, banking chaos ensues with termination of operations of Second Bank; money, which has to be shifted from vaults of Second bank to state banks, goes into transit along waterways, wagon-ways, and railroads, and is thus not available to facilitate commerce.
1837 to Civil War, banking and economic instability, but paper money supply issued by reputable state banks is generally convertible to gold at face value (par); money issued by distant or "unknown" banks circulates at discount from par (e.g., 93 cents on the dollar).
1860-65, Civil War finance requires issue of paper money by governments on both sides; paper money is over-issued by state chartered banks and by both governments; excessive issue of Union (North) treasury notes, known as "greenbacks," eventually results in circulation at discounts from par; same occurs for Confederate (South) money, but even worse; at war's end Confederate issues of money become worthless, Federal greenbacks continue to circulate at discounts.
1865-1914, in the absence of a central bank to exercise control over the banking system, the Treasury Department begins to learn and exercise some central banking functions; by the turn of the century there is widespread recognition of the inflationary potential of allowing the same governmental office responsible for financing government's expenditures to also be responsible for providing and controlling its money supply; demands for monetary reform become more out-spoken.
1869-75, first American "Great Depression" follows from deliberate withdrawal of paper money by Congressional act to eliminate discount from par, with the objective to reestablish convertibility of currency to gold at par.
1875-90, era of Bimetalism; silver mining interests demand governmental support so Congress passes legislation to define sixteen ounces of silver as equal in value to an ounce of gold, and par values are determined between the dollar and both metals in the ratio of 16:1; but relative market values of gold and silver change; for a while gold is overvalued at the mint, and so is drained from circulation (mostly to Europe) and replaced by silver; later silver becomes overvalued and is drained from the economy to Europe (gold flows in from Europe); consequent economic instability ensues as gold flows into and out of the country, thereby affecting the domestic money supply; eventually bimetallism is ended and the U.S. government defines the value of the dollar exclusively in terms of gold, thereby committing to the international Gold Standard.
1880, beginning of charter of "National Banks" by Federal Government; state banks are prohibited from further issuance of bank notes; only National Banks chartered by Federal Government are authorized to issue bank notes, but most banks choose to remain state banks in order to avoid control by Treasury; money supply begins transition from mostly paper money to mostly demand deposits.
1880s until 1914, banking instability continues; money supply is inflexible in sense that much of the money is in bank vaults in the cities when it is needed in rural areas to facilitate planting, harvest, and vice-versa; banking panics precipitate numerous episodes of economic instability which seem to worsen.
1912-14, Congress debates the need for a central bank and the shape it is to take; the need for independence from the Treasury is a critical issue; Federal Reserve Act is passed by Congress in 1914.
1914-1932, Federal Reserve System (FRS) begins to operate, learns central banking functions; National Banks lose authority to issue currency; this authority becomes exclusive function of FRS in order to provide uniform currency and flexible money supply; number of state as well as national banks increase, state banks by much larger numbers because of FRS regulation of National banks; bulk of money supply is now demand deposits rather than currency.
1929-32, economy goes into recession with collapse of business confidence after boom decade of 1920s; output and employment contract by nearly 25 percent.
1932-36, banking system collapses; FRS Board fails to comprehend its mission of being "lender of last resort" to the commercial banks, or that it is fundamentally different from commercial banks in that it cannot fail; FRS lets the money supply drop drastically as it mistakenly attempts to decrease its outstanding deposit liabilities in order to keep itself from failing; as FRS decreases its deposit liabilities (deposits of commercial banks), commercial banks cannot meet reserve requirements, call loans many of which are bad, become insolvent, fail; banking population drops from over 30,000 to less than half; the U.S. suspends nationalizes all gold in the country and suspends gold payments to foreigners, thus goes off Gold Standard.
1936, with monetary stringency, interest rates rise in the U.S. relative to Europe, initiate capital inflow, supplies American banks with excess reserves which FRS officials view with alarm as having great inflation potential; FRS does not realize that bankers wish to hold idle excess reserves for liquidity; FRS raises reserve requirements to "mop up" excess reserves, precipitates another bank crisis, monetary contraction, second downturn and depression trough.
late 1930s, gradual recovery as FRS officials begin to comprehend effects of their actions and cease decreasing reserves and the money supply.
early 1940s, beginning of WWII, FRS takes subsidiary role to Treasury, assists with war finance, i.e., keeping interest rates low, which lets money supply increase, causing inflationary pressures; inflation is contained because of price controls and rationing during war.
late 1940s, rationing and price controls are lifted at war end; pent-up inflationary pressures are released, causing a significant amount of inflation; the U.S. participates in forming the Bretton Woods international monetary system by committing to fix the value of the U.S. dollar to gold so that other countries can fix the values of their currencies to the dollar (a pseudo Gold Standard).
1951, FRS reaches accord with Treasury to regain its autonomy and independence, acts to raise interest rates and restrict the money supply to control inflation;
1952-60, prices remain stable through rest of '50s; recession emerges in 1958 in second Eisenhower administration, the first on record with both rising unemployment and rising prices; "stagflation" is born.
early 1960s, Kennedy administration early "supply side" tax cut stimulates growth; FRS pursues interest rate as monetary target due to Keynesian theoretical influence, thus lets money supply expand to keep interest rates under control; inflationary pressures worsen.
late 1960s, initiation of Viet Nam war which requires increased military expenditures added to President Johnson's "Great Society" social welfare spending programs; adds significant inflationary pressures; FRS targeting of interest rate allows monetary aggregates to expand to keep interest rates low, fuels accelerating inflation.
In the post-WWII period the U.S. runs chronic balance of payments deficits due to Marshall Plan, American tourism, American overseas investment, growing imports of foreign merchandise; but the U.S. for a while maintains the value of the dollar to gold by depleting its monetary gold stock; in 1971, confronted with continuing decline of the U.S. monetary gold stock, President Nixon suspends domestic redemption of currency into gold; by 1973 Nixon suspends international gold payments by the U.S., thus ending the Bretton Woods international monetary system and initiating a flexible exchange rate system.
early 1970s, Nixon administration tries wage-and-price guidelines, but is unsuccessful in containing inflation; Nixon resigns in Watergate scandal in 1974, succeeded for two years by President Ford, then President Carter is elected in 1976.
late 1970s, inflation psychology emerges with growing budget deficits, rising nominal interest rates; with crowding-out effect threatened, Fed acts to expand money supply to prevent further interest rate increases, but this only aggravates the inflationary pressures.
1979, Paul Volker is appointed by Democrat President Carter to be Chair of the Federal Reserve Board of Governors, but Volker turns out to have monetarist leanings rather than Keynesian, and redirects FRS policy away from interest rate targeting and toward control of monetary aggregates so as to reduce the rate of growth of the money supply.
1981-82, Volker monetary stringency precipitates deep though brief recession, but inflation psychology is broken and monetary and economic stability follow.
1983-90, Reagan administration cuts taxes, pursues other "supply side" policies which, coupled with careful control of monetary aggregates, initiates longest period of sustained U.S. expansion on record; FRS now indoctrinated in the need to pay more attention to monetary aggregates than interest rates as target of monetary policy.
1980s and 1990s, failure of nearly a quarter of the more than 3200 savings and loan associations, requiring bailouts totaling nearly $90 billion; new home construction slows, contributing to early '90s recession.
late 1980s, President George H. W. Bush says "no new taxes" as a campaign promise, but confronted with rising Federal budget deficits, raises taxes after election; this brings about the end of the long expansion in 1990 and Bush's defeat in 1992.
1989, enactment of FDIC Improvement Act requires all banking institutions receiving deposits to insure with the FDIC and all such institutions to come under the regulation of the Federal Reserve.
early 1990s, after Volker's retirement, the Greenspan FRS continues to give lip service to monetary aggregates and to targeting a range of growth for M2, but begins to give occasional attention to interest rates as Federal government runs ever larger budget deficits; Clinton elected President in 1992, raises taxes more in effort to control budget deficit, precipitates recession; interest rates at post-WWII lows as outside world purchases U.S. government bonds, thereby assisting the U.S. in financing its budget deficit without interest rate increases.
1993-94, recovery occurs gradually with FRS leaning against monetary expansion; FRS raises discount rate five times during 1994, the latest being a 3/4 percent increase in mid-November 1994; long-term interest rates continue to rise, indicating that capital markets think that not enough has yet been done by the FRS to impose monetary stringency and avert inflation.
1999, Glass-Steagall Act repealed, removing separation between investment banks and depository institutions; this repeal is thought by many banking analysts to have contributed to financial crisis in 2007-2010.
late 1990s, early 2000s, wave of banking mergers among larger banks and acquisitions of smaller banks; many larger depository banks begin investment banking operations.
late 2000s, worst financial crisis and recession since the Great Depression of the 1930s; liquidity shortage in the banking system contributes to collapse of financial institutions and elicits bank bailouts by the government; stock market market suffers major decline; housing foreclosures contribute to construction decline and business failures in related fields; investor confidence collapses; government responds with massive fiscal stimulus which fails to have intended effect; Federal Reserve responds by lowering interest rates to near zero and so-called "quantitative easing" which greatly increases bank reserves; increasing excess reserves support little additional lending; unemployment increases toward 10 percent of the labor force; economic growth near zero.
2010, Congress temporarily increases deposit insurance limit to $250,000, passes Dodd-Frank Wall Street Reform and Consumer Protection Act to improve regulatory oversight of the banking system.
2010-2011, financial crisis begins to ease; unemployment begins slow decline; economic growth increases toward 2 percent per year; government budget deficit and accumulating public debt become central presidential campaign issues; Fed promises to keep interest rates low indefinitely.
Lessons from U.S. Monetary and Banking History:
1. One society can use another society's money.
2. Banking innovation often occurs in response to the needs of war finance.
3. Free (or uncontrolled) commercial banking typically results in banking and currency chaos.
4. Gresham's Law: Bad money drives out good; cheap money drives out dear; debt money replaces commodity money; paper money replaces metallic money.
5. Disruptions to the banking system often are caused by misguided government policy.
6. No more than one monetary standard can be in effect at any one time.
7. If part of a nation's money supply becomes unavailable for circulation, its volume of commerce likely will contract.
8. Over-issue of the money medium results in the depreciation of its purchasing power.
9. The fiscal and monetary functions of government should be separate because of an inherent potential for inflation.
10. Central banking is fundamentally different from commercial banking; one is profit-oriented, the other is control-oriented.
11. Unlike a commercial bank, a central bank cannot fail.
12. A nation's money supply needs to be flexible and responsive to the needs of commerce and growth.
13. Commodity monies are strictly limited in quantity; debt monies can be expanded without limit (but with consequences).
14. Bankers may desire to hold reserves greater than they are required by law or authority to hold.
15. International capital flows can change a nation's commercial bank reserves and its money supply.
16. The central bank's commitment to a fixed exchange rate may deplete the nation's stocks of gold and foreign exchange.
17. A monetary policy of targeting interest rates is likely to cause monetary expansion and contribute to inflation.
18. A monetary policy of targeting the growth of a monetary aggregate (such as M2) can alleviate inflation, but with some undesirable side effects.
19. Price controls and rationing can only suppress inflationary pressures, not eliminate them.
20. If the monetary authority is subjugated to the fiscal authority, inflation is a likely consequence.
21. Efforts by the monetary authority to prevent crowding out of private investment usually results in monetary expansion and may contribute to inflation.
22. Supply-side fiscal policies may be able to stimulate an economy without causing inflation.
23. If the demand for bonds is increasing, it may be possible for government to finance its deficits without causing interest rates to rise.
24. A central bank can dictate only its own interest rate, but not market-determined interest rates.
25. Simply raising the central bank's interest rate may not achieve monetary restraint; the banking system's reserves must be decreased.
26. Simply lowering the central bank's interest rate may not achieve monetary stimulus; simply increasing the banking system's reserves may not achieve monetary stimulus.
27. Monetary expansion may produce price "bubbles" in areas other than measured by common price indexes, e.g., in financial, housing, and commodities markets.
28. Virtually any regulation imposed in the financial sector eventually will be circumvented by financial innovation.
29. Mixing depository and investment banking may have detrimental effects on the financial system.
30. Open market operations to provide banks with additional reserves (a.k.a. "quantitative easing") may not elicit additional bank lending if bankers
The U.S. banking system is peculiar in a number of respects, including
National banking systems in other countries typically exhibit different characteristics.
It is also a misimpression that these two banks were central banks. In fact, they were both constituted by Congress to function as commercial banks which could also serve the interests of the government as fiscal agent and lender to it. The concept of "central bank" had not yet emerged by these times. Even the Bank of England, chartered by the Crown in 1684, first operated as a commercial bank in the interest of the founding merchants before the Crown discovered its usefulness as lender to the Crown.
The functions of central banking, which did not reach full development until well into the 20th century, were only beginning to emerge by process of discovery. The managers of the first Bank of the United States discovered that they could accumulate the notes issued by state banks for presentation to them for redemption in specie, thereby constraining the over-issue of notes by the state banks. The officers of the "independent Treasury" between the Civil War and 1913 discovered that they could by judiciously purchasing or selling Treasury obligations affect the deposits of the banking system, a practice implemented subsequently by the Federal Reserve System as "open market operations." The concept of the maintenance of reserves against deposit liabilities gradually emerged in commercial banking in the 18th and 19th centuries before it was perceived late in the 19th century that a banking authority might legally impose a reserve requirement. Although the first and second Banks of the United States were not true "central banks," they had begun to discover some central banking prerogatives and functions.
The 19th century was a period of transition from commodity monies to debt monies. Most of the monies in use throughout the world prior to the 19th century were precious metals, mostly gold and silver. Their quantities were thus constrained by the amounts which could be discovered, mined, refined, and not used otherwise for non-monetary purposes. Particular countries might increase "the wealth of the nation" by pursuing a favorable balance of trade (Adam Smith's view of Mercantilism) or sponsoring piracy on the high seas. During the commodity-money era, localized episodes of inflation were attributable to fortuitous circumstances of precious metal discoveries or the influx of specie via trade or piracy. Also during this era the world economy began to grow faster than the stocks of commodity monies could expand, and this tended to have a deflationary "drag" effect on the world economy's growth. To relieve this problem, debt monies (notes and deposits) for which no physical or technical constraints exist began first to augment and eventually to supplant commodity monies. Because debt monies had become the norm in the industrially advanced and financially mature regions of the world by the end of the 19th century, 20th century inflation became attributable to discretionary actions by government officials.
The needs to deal with war debts (of the Revolutionary War and the War of 1812) played roles in the establishment of both the first and the second Banks of the United States.
President Andrew Jackson, who had suffered some bad early experiences with banks and bankers, resolved to make the Treasury independent of the banking system. He thus made non-renewal of the charter of the second Bank of the United States an issue in the presidential election of 1832. The expiration of the Bank's charter in 1836 precipitated a depression (much of the government's money was for months in transit from the hinterlands to the Treasury's vaults in Washington, and thus not in banks serving as reserves) and resulted in an absence of an explicit central bank in the U.S. until 1913.
The chaotic condition of the state-bank issued heterogeneous paper currency between 1836 and the Civil War was an environment in which counterfeiting was rampant. To the extent that counterfeit notes circulated, they increased the effective money supply and contributed to inflationary pressures. Two episodes (1849 in California, 1890 in the Yukon) of fortuitous gold discoveries resulted in booming economic conditions and inflationary pressures.
Military operations during the Civil War became financed on both sides more by note issue than by either taxes or borrowing, with consequent inflationary pressures. The Confederate currency of course became worthless at the end of the war. The Union currency ("greenbacks") circulated at discount from par (face) value after the war because of fear that the government did not have enough gold and silver to redeem all of the paper money that had been issued. This resulted in a popular demand for the reestablishment of sound paper money redeemable in gold or silver at face value.
The effort by Congress to restore the convertibility of paper money at par led to a decade-long period of deflation and depression (the first "Great Depression" of the 1870s) when the excessive quantities of war-issued paper money were withdrawn in payment of taxes which were impounded. Congress, under pressure during the 1880s and 1890s by silver interests to establish a bimetallic monetary standard, enacted a mint parity ratio of 16 ounces of silver to an ounce of gold. Since the market value of an ounce of gold was slightly higher than 16 ounces of silver, this mint parity ratio resulted in over-valuation of silver at the mint, draining the mint of gold and causing it to flow overseas. In the effort to correct this problem, Congress subsequently changed the mint parity ratio to 16.5:1, which overvalued gold at the mint, causing gold to flow in and silver to flow overseas. Finally, toward the end of the decade gold was designated as the sole monetary standard and remained so until 1933.
Between the Civil War and 1913, officers of the Treasury Department discovered that they could affect the reserves of commercial banks by judiciously impounding tax revenues and subsequently releasing them for disbursement at propitious times, and by purchasing and selling Treasury obligations for the Treasury's own account (the precursor of open market operations). These activities resulted in the ("independent") Treasury functioning as a de facto central bank during this interval, a fact which led to calls for Congress (the legislative branch of government) to establish a real central bank which would be independent of the Treasury (a part of the executive branch of government).
Fears of concentration and centralization of power led to the enactment of legislation in 1913 which established a federal system of 12 regional central banks, each of which functioned essentially independently of the others until the crisis of massive bank failures during the Great Depression of the 1930s.
The governors of the Federal Reserve at the eve of the 1930s Great Depression still did not possess adequate concepts of "central banking" and the roles which central bankers should play in a banking crisis. Many of them had come to the "Fed" from positions of management of commercial banks, and they tended to regard the Fed as just another, but very large, commercial bank. Thus when commercial banks began failing en mass, these governors perceived their mission to be to avert the potential for failure of the Federal Reserve by protecting its assets and diminishing its liabilities (including the reserves of commercial banks). In so doing, they decreased the reserves of the commercial banking system at the very time when the system needed more reserves to stem the tide of bank runs. Because they had not yet perceived that the Fed itself could "fail" only when terminated by Congress, they indulged in a failure of mission with respect to the safety of the banking system.
Bankers do not lend their excess reserves; they create new money as a by-product of issuing loans. The borrower and the lender exchange claims against each other. The loan customer issues a claim against him/herself in the form of a promissory note; the bank issues a claim against itself in the form of an addition the borrower's deposit account. Neither claim existed prior to the negotiation of the loan. The former claim is not money, but the latter claim is money. Hence, money is created as a by-product of loan issuance, and it may be said that the debt has been monetized.
While banks technically can create any amount of money that bankers wish when they issue loans, the effective limit is the amount of the bank's excess reserves. Inevitably, borrowers pay other parties by checks, which results in adverse clearings against the lending bank, thereby causing loss of reserves to the bank (although gains of reserves to other banks. The bank may suffer negative excess reserves (i.e., a reserve deficiency) when lending exceeds available excess reserves and checks written by borrowers clear against the bank. This may easily occur in a bank with multiple branches.
A reserve deficiency must be remedied in timely fashion, else deposit customers will lose confidence in the bank or central bank authorities will discipline the bank. Central bank discipline options include requiring the commercial bank to alter lending criteria, reassigning or dismissing loan officers, indictment of officers for fraud, suspending operations of the bank, forcing the bank to cease operations (i.e., sell its assets and liabilities to other banks), and terminating the bank by using deposit insurance funds to pay out depositors.
The bank may remedy a reserve deficiency by (a) loan attrition, (b) borrowing other banks' excess reserves (only over night), (c) selling market assets, (d) calling loans, or (e) borrowing from the central bank. Since central banks usually are constituted to serve as "lenders of last resort," there is stigma attached to routine borrowing of too much, too often, or for too-long periods of time.
The side-effect of open market purchases/sales of government bonds (actually of anything) is to increase/decrease the monetary base (MB). The monetary base consists of commercial bank reserves plus currency in circulation. Portions of the monetary base may be used for (or siphoned off into) domestic cash holdings by the public outside of the banking system (i.e., no cash held within the banking system is part of the money supply in circulation or the monetary base), foreign cash holdings, meeting central bank reserve requirements, or desired excess reserves. The propensities for these leakages to occur are specified, respectively, as cd, cx, rr, and dr, each of which is a ratio relative to checkable deposits. The remaining portion of the monetary base constitutes excess reserves which may enable additional lending by commercial banks and precipitate multiple deposit expansion through a relending process. Bankers, as a matter of prudence, would keep desired reserves even if the central bank did not require reserves (i.e., even if rr were 0, dr would be greater than 0).
The simple deposit multiplier is the reciprocal of the required reserve ratio, 1/rr, assuming no leakages of the monetary base into cash or travelers check holdings by the public, savings or time deposit holdings by the public, or the maintenance of desired excess reserves by bankers. The monetary base can be used by the public as domestic cash holdings (C), as foreign cash holdings (CX), or by commercial bankers as reserves (R), i.e., MB = CD + CX + R.
The complete domestic checkable deposit multiplier is the reciprocal of the sum of the deposit leakage propensities, i.e., 1 / (cd + cx + rr + dr). The impact upon commercial bank deposits of a change of the monetary base can be computed as the checkable deposit multiplier time the change in the monetary base.
The domestic currency multiplier is the currency-to-deposit ratio (cd) divided by the sum of the deposit leakage propensities, i.e., cd / (cd + cx + rr + dr). The impact of a change of the monetary base upon the amount of currency in circulation can be computed as the currency multiplier times the change in the monetary base.
The domestic M1 money supply includes currency held outside of banks plus the checkable deposit liabilities of banks and travelers checks. Using tc as the ratio of travelers checks to checkable deposits, the M1 money multiplier is (1 + cd + tc) divided by the sum of the checkable deposit leakage propensities, i.e., (1 + cd + tc) / (cd + cx + tc + rr + dr). The impact on the M1 money supply of a change in the monetary base can be estimated as the product of the M1 money multiplier times the change of the monetary base.
The M2 specification of the money supply includes (in addition to the contents M1) savings deposits, small time deposits (non-negotiable of denomination less than $100,000), money market deposit accounts, money market mutual fund shares (not owned by institutions), overnight repurchase agreements, and overnight Eurodollars held by U.S. residents in offshore deposits at U.S. bank branches. Using td as the ratio of savings and small time deposits to checkable deposits and m as the ratio of all other components of M2 to checkable deposits, the M2 money multiplier may be specified as (1 + cd + tc + td + m) / (cd + cx + tc + rr + dr). The impact on the M2 money supply of a change in the monetary base can be estimated as the product of the M2 money multiplier times the change of the monetary base. Relative to the M1 multiplier, the M2 multiplier adds two components to the numerator without adding any leakages to the denominator. Consequently, the M2 multiplier is larger (often 10 or more) than the M1 multiplier (usually less than 3).
Of the determinants of the money supply, MB, rr, cd, cx, tc, td, and dr, the first two are controlled by the central bank, the third, fourth, fifth, and sixth by the public, and the seventh by commercial bankers. The monetary base (MB) is increased/decreased by central bank purchases/sales of government bonds (actually anything that the central bank chooses to purchase or has to sell). There is thus no limit to the ability of the central bank to increase commercial bank reserves; its limit to decrease commercial bank reserves is its asset portfolio.
The money multiplier is increased/decreased by the central bank's lowering/raising the required reserve ratio (rr). However, changes of rr do not change the amount of reserves, only the composition of reserves between required and excess. Reserve ratio increases may precipitate falling bond prices as many banks attempt simultaneously to sell bonds. Such adverse price changes may render banks insolvent as asset values decrease relative to liabilities
The money multiplier is increased/decreased by the public's decreasing/increasing preferences to hold cash relative to deposits, i.e., cd. The money multiplier is increased/decreased by bankers' preferences to decrease/increase holdings of desired excess reserves, i.e., dr. Bankers' preferences for holding excess reserves vary inversely with interest rates on customer and market assets, directly with risk of deposit withdrawals, and inversely with reserve borrowing rates (discount and federal funds). The public's preferences for holding cash relative to deposits vary inversely with interest rates on checkable deposits, directly with fees on checkable deposits, inversely with income, directly with probability of bank failure, directly with the level of underground activity (legal or illegal), and directly with the level of tax rates on income which is easily monitored (i.e., for which there are accounting trails).
The money supply (Ms) is exogenous (and the money supply curve vertical relative to the interest rate) if cd and dr vary randomly; "exogenous" means outside the banking system, i.e., determined completely by the central bank. The money supply (Ms) is endogenous (and the money supply curve upward sloping left-to-right relative to the interest rate) if cd and dr vary systematically with changes in the interest rate on customer loans.
It is important to recognize that if there is no banking authority, or if the banking authority does not specify a reserve requirement, bankers would as a matter of prudence choose to keep reserves against deposit liabilities. The more risk averse bankers likely would maintain a higher ratio of reserves against deposit liabilities, whereas bankers who are less risk averse might maintain a lower ratio. The average of these ratios for the entire banking system could be referred to as a "desired reserve ratio."
Even in such countries as the U.S. where the monetary authority imposes a required reserve ratio, empirical evidence suggests that bankers typically maintain a margin of excess reserves above the required reserve ratio. They likely do this in order to meet deposit withdrawal contingencies since the reserves required by the monetary authority really are not available to meet withdrawal liquidity needs. The real reason for a monetary authority to impose a reserve requirement is to maintain control over its banking system's reserves, rather than to ensure the liquidity of the banks in its system. This latter objective is served by the "lender of last resort" function of a central bank.
To the extent that commercial bankers do maintain margins of excess reserves, the desired reserve ratio is greater than the legally required reserve ratio. It is thus a more severe constraint upon the individual commercial bank's loan production function, as well as upon the money creation potential of the banking system, than is the required reserve ratio.
An increase of the required reserve ratio has the effect of converting excess reserves into required reserves. If desired reserves were large enough relative to the reserve requirement, a moderate increase of the required reserve ratio may not have immediate effect upon bank lending or the money supply. Bankers may choose to absorb a moderate increase of the reserve requirement without having to immediately reduce their outstanding loan portfolios. If banks are given adequate time to adjust to an increase of the required reserve ratio, a preferred means for decreasing the size of a bank's loan portfollio is to issue no (or few) new loans while outstanding loans are paid down or paid off.
A required reserve ratio increase that is large enough to wipe out desired excess reserves and put banks into deficit reserve positions will force a decrease of outstanding lending and hence the money supply. A large enough required reserve ratio increase may precipitate a drastic response by bankers to call in outstanding loans.
A decrease of the required reserve ratio has the effect of converting required reserves into excess reserves. If bankers desire to hold more excess reserves, a required reserve ratio decrease may not have an immediate effect on bank lending or the money supply. Bankers may simply choose to bring their reserve holdings up to desired levels without increasing lending. Also, in a recession environment, bankers may not be able to use their newly designated excess reserves to increase lending if prospective borrowers perceive few profitable investment opportunities.
Commercial banks are sometimes described as lending out their excess reserves. They do not do this except in the case of making loan proceeds available to customers in the form of currency. What usually happens when a loan is made is that the borrower issues a claim against him-/herself in the form of a promissory note; in exchange the bank issues a claim against itself in the form of an addition to the borrower's checkable deposit account. Neither claim existed prior to the negotiation of the loan; both claims were called into existence when the loan was made. The promissory note issued by the borrower is not money, but the addition to the account balance issued by the bank is money. Hence, new money is created consequent upon the bank's monetization of the borrower's debt.
In all likelihood the borrower, very soon after negotiating the loan from the bank, writes one or more checks on the account containing the newly-issued money to make purchases. The sellers receiving the checks deposit them in their own bank accounts. The lending bank then suffers adverse clearings, thereby losing the excess reserves which enabled the extension of the loan in the first place. Although the net effect of this process may be the appearance that the bank has only lent its excess reserves, the bank has not actually lent its excess reserves; it has lent newly-created money and lost reserves in the check-clearing process.
The reason that this point is so significant is that if the bank can lend only its excess reserves, there is no way of explaining how the bank might by mistake or intent issue loans which total more than its excess reserves. But this is indeed a possibility and a not-too-unusual actuality. The consequence is that when checks written by borrowers against the increments to their deposit accounts clear the system, the bank finds itself in a deficiency reserve position.
Technically, a bank has the ability to issue loans (and hence create new money) in any amount. But it is constrained either by law (a legal reserve requirement) or by prudence (the need to maintain the confidence of the public in the bank's ability to meet withdrawal requests upon demand) to issuing loans which are no greater in total than the excess of its required or desired reserves, whichever is greater. A banker who with fraudulent intent issues loans significantly in excess of the bank's excess reserves can do this about one time and had better plan to accompany his loan customer on the next flight to Rio after they have cashed checks against the deposit receiving the loan proceeds.
It is not unusual for a bank with a number of branches to find itself in a deficit reserve position even though its management is not particularly risk-oriented and does not exhibit fraudulent intent. It can happen simply because branch managers (and assistant branch managers as well) may double as loan officers who are authorized to approve loans on their own authority up to some specified maximum amount. It may not be until the end of the day or even the next morning before loan approval totals for the previous day are in to the operations center, at which time it is discovered that the bank's new loan commitments exceed its excess reserves over the eligible period.
So, what are the implications if a bank's management finds the bank in a reserve deficit position relative to legal requirements or even relative to the bank's own preferences for maintaining reserves? A reserve deficiency relative to managerial preference may have no legal implications, but it may jeopardize the bank's ability to meet withdrawal demands. Should this happen, the public's confidence in the bank may suffer and a run on the bank may be threatened. If the bank finds itself with a reserve deficiency relative to legal requirements, it is under legal obligation to repair the deficiency as soon as possible. In either case, its options in descending order of priority are as follows:
(1) If the bank has enough time it can rely upon loan attrition, given the large numbers associated with its loan business. The bank typically has a large number of existing loan customers with loan terms and payment due dates randomly distributed. And, on any single day the bank can expect some number of new loan applications. Given sufficient time, all that is necessary is to suspend any new loan approvals until an adequate amount of loan pay-downs or pay-offs have been received to diminish the outstanding deposit total to the level that can be "covered" by the existing reserves. We are reminded that money is created (added to deposit accounts) when loans are extended, but money is destroyed (deducted from deposit accounts) when loans are paid off.
(2) If the bank does not have enough time to rely on the loan attrition process, the next easiest remedy may be to borrow other banks' excess reserves for short periods (usually over night) from the Federal Funds Market. The cost is the federal funds rate which usually is only slightly higher than the so-called "discount rate" (the interest rate available to commercial banks which borrow at the Federal Reserve's discount window). Occasionally the federal funds rate even drops below the discount rate. The positive which recommends this remedy is that Federal Funds borrowing does not raise red flags with banking authorities.
(3) Although the bank may "buy some time" by borrowing Federal Funds, a longer-term solution may require it to dispose of some of the market assets in its investment portfolio, usually U.S. Treasury obligations, in order to increase its holdings of reserves. Banks have a dual incentive to hold some market assets: they yield interest income, though usually at rates below those on customer loans; and they can provide a cushion of liquidity in times of reserve deficiency. The existence of an open market allows quick sale of the market assets with little loss of value unless many commercial banks simultaneously find themselves in reserve difficulty and are all trying to unload market assets in order to get additional reserves.
(4) The bank may have insisted on loan call provisions in the promissory note contracts which they have accepted. Calling loans (demanding repayment of principal before maturity date) is a means of decreasing outstanding deposit liabilities against which reserves are maintained, but to do so regularly will confer upon the bank a reputation for it and likely alienate the bank from its loan customers.
(5) In the U.S., the Federal Reserve's discount rate is usually (though not always) the lowest borrowing rate which commercial banks can get, and bank managers are tempted to rely on the Federal Reserve borrowing as a source of additional reserves when needed. However, the Federal Reserve Act of 1913 constitutes the U.S. central bank as a "lender of last resort." While the Federal Reserve's discount window is always open to assist commercial banks during periods of stringency, no bank should abuse the borrowing privilege by borrowing too much, for too long periods of time, or too often. To do so would "raise red flags" which would invite examinations and audits by banking authorities such as the Federal Reserve itself, the Federal Deposit Insurance Corporation, the Comptroller of the Currency, or state banking authorities. Should any of them find overt wrong-doing or even questionable practices, the range of remedies open to them include:
(b) requiring the bank to discipline or even dismiss certain loan officers;
(c) indicting and prosecuting bank officers for fraudulent or other criminal activity;
(d) requiring the bank to suspend operations until problems have been addressed satisfactorily;
(e) forcing termination of the bank's operations and sale of its assets (including customer loans) and liabilities (including customer deposits) to other banking institutions; and(f) if the bank has become illiquid in the sense of being unable to satisfy all depositors, the F.D.I.C. may decide to redeem deposit accounts from its accumulated premium fund.
It is sometimes said that tangible assets (such as houses or shares of stock) are bought and sold in equity markets. The stock market is an equity market, but shares of stock represent ownership in the company which issues them. The stock shares are no more tangible than are bonds which are claims against the issuing firm or government entity and which are sold in debt markets. Houses certainly are tangible, but there is no particular reason to classify the market in which they are sold as an equity market. Houses are inventory assets to their builders, and they become personal assets of their purchasers. The mortgages issued by the mortgage lenders are assets to the mortgage lenders, but they are liabilities to the home purchasers. The purchaser possesses "equity in the house" only to the extent that its value exceeds the mortgage(s) on it. The purchaser's equity in the house may increase as the house appreciates in value or as the purchaser pays down on the mortgage, but this is not a basis for saying that houses are sold in equity markets. The home owner's "balance sheet equity" is the general quantitative amount by which the asset total exceeds the liability total, but this equity cannot be associated with any specific asset such as the house. Hence, this also is not a basis for classifying the housing market as an "equity market."
Dealer and brokerage functions should not be confused. A dealer takes title to inventory and then transfers title to the purchaser. A broker "makes trades" but never takes title to the inventory.
Regulatory change has blurred the distinction between commercial banks and savings institutions. Both types of institutions now are subject to the same regulatory agency, the Federal Reserve System. And many of the former S&Ls have attempted to "reinvent themselves" as banks, including changing their names. Example: in South Carolina, the former American Federal Savings and Loan Association has become the American Federal Bank, and it is now being acquired by a North Carolina banking interest.
A mortgage borrower might be willing to "pay points" (a point is 1 percent of the mortgage amount) as prepayment of interest if this lowers the interest rate by enough so that over the life of the loan the borrower saves more in interest than the amount of the point paid. Due to the efficient nature of the mortgage market, it is often a "toss up" as to whether the point is worthwhile in terms of the interest saved.
Government securities are debt instruments issued by the U.S. Treasury. From the Civil War forward until the 1950s, the Treasury also issued "Greenbacks" and other Treasury notes which like Treasury bonds were also debt obligations of the U.S. Treasury. Unlike Treasury bonds, the Treasury notes entered the money supply with inflationary implications. Today, the Treasury no longer issues paper currency (deferring this function to the Federal Reserve), and the remaining $10 billion or so in outstanding Treasury notes mostly are in numismatic collections.
Economists often speak of "the" interest rate as if there is only one interest rate, but in reality there is a range of nominal interest rates that differ from one another due to risk differentials and the differing durations of the lives (terms) of financial instruments. Also, when we speak of "market interest rates" on financial instruments we do not mean to imply that interest rates themselves are bid and offered in financial markets. What is meant is that interest rates are the yield rates that are computed from information about the market prices of the financial instruments.
So what determines interest rates and why do they change? This is a perplexing question since principles of economics textbooks typically retail to students of economics half a dozen explanations of interest rate determination. The media (print, audio, video) seem to fixate upon the conventional wisdom that the central bank (in the U.S., the Federal Reserve) sets and changes interest rates.
Theories typically elaborated in economics textbooks are that (1) the scarcity of real capital determines the true interest rate, (2) the loanable funds market determines the market interest rate, (3) the interest rate is determined by the demand for and supply of money, (4) in the bond market, the demand for and supply of bonds determines bond prices, and hence yield rates, (5) nominal interest rates vary with changes in the expected rate of inflation, and (6) changing risk factors cause nominal interest rates to vary.
We emphasize that there is no such thing as "the interest rate". Globally there are as many different interest rates as there are yield bearing circumstances. In each locale there is a whole structure of interest rates which differ by investment type, term, risk, and yet other circumstances. In the following discussion, unless otherwise specified, the term "the interest rate" shall be used to refer to the general level of the structure of interest rates. A brief elaboration is presented for each of the usual interest rate theories, followed by an attempt at reconciliation and integration of the theories.
The Scarcity of Real Capital
The Demand for Money Relative to the Supply of Money
The Demand for Money. As illustrated in Figure 1, an increase of the price level or the real income level causes the demand for money to increase (shift to the right) from D1 to D2. At interest rate i1, the quantity demanded, M2, exceeds the quantity supplied by the amount represented by line segment AB. Assuming that the money supply has not changed, the interest rate rises from i1 to i2 so that the new equilibrium is at point C. At the higher interest rate, the quantity of money demanded has decreased to M1, the amount which is in circulation.
The Supply of Money. Figure 2 illustrates an easier (or looser) monetary policy implemented through open market purchases of bonds which shifts the vertical money supply from S1 to S2. At interest rate i1, there is more money in circulation than people want to hold in the amount represented by line segment AB. Assuming that the demand for money has not changed, this induces the interest rate to fall to i2, so that the new equilibrium is at point C.
The Efficacy of Monetary Policy. A cautionary note is warranted at this point. Efforts by a central bank to increase interest rates by decreasing the supply of money (or reducing the rate of increase of it) may not have the intended effect if people choose to get more money to hold by cutting back on their purchases of goods and services rather than by selling financial instruments. Likewise, central bank efforts to cause interest rates to fall by expanding the money supply may not be effective if people use their excess money balances to purchase goods and services rather than buy financial instruments. In both cases, the impacts may be more upon the price level than upon interest rates, but this may have been the ultimate objective of central bank policy anyway.
Equilibrium. There is only one interest rate that can equilibrate the demand for money with the supply of money. Any interest rate above the equilibrium level results in an excess supply of money relative to the amount which people want to hold at that interest rate. By the same token, any interest rate below the equilibrium level results in an excess demand for money to hold relative to the amount in circulation. However, the money demand-supply relationship does not contain within itself a mechanism to cause the interest rate to change or to achieve equilibrium. A connection to the bond market must be made for this purpose.
The Bond Market
effective yield = (face value at maturity - current price) / current price
Suppose that a bond has a $1000 face value, provides no coupon interest payments, and is sold and traded at some price which is discounted from face value. At a current market price of $900, the effect yield is ($1000 - $900) / $900, or approximately 11.1 percent. If the market price should rise to $910, the effective yield, ($1000 - $910) / $910, would fall to approximately 9.9 percent.
The Demand for Bonds. In the bond market, demand and supply are presumed to be normally sloped relative to the prices of the bonds as illustrated in Figures 3 and 4. Since financial instruments exhibit a wide range of denominations, the "quantity of bonds" on the horizontal axis should be understood not in terms of a number of such financial instruments, but rather as an amount of financing demanded or supplied by such instruments. For purpose of exposition, a standard bond of fixed denomination, e.g., $1 million, might be assumed so that the horizontal axis units can be understood as the number of such bonds. An increase in the demand for bonds from D1 to D2 in Figure 3, other things remaining the same relative to the supply of bonds, results in an increase in the price of bonds from P1 to P2, and a corresponding fall in their yield rates. If the demand for bonds should decrease from D1 to D3, the price of bonds would fall to P3 and the yield rates would rise.
The Supply of Bonds. Bonds are supplied by corporations seeking funds to finance investments, and by governments needing to finance budgetary deficits. In Figure 4 an increase in the supply of bonds from S1 to S2, other things the same for the demand for bonds, results in a decrease in the price of bonds from P1 to P2, with corresponding rise in the yield rate. A decrease in the supply of bonds to S3 would elicit an increase in the price of bonds to P3 and a fall in their yield rate.
When the demand for money increases in Figure 1, line segment AB represents an excess of demand for money to hold relative to the amount in circulation. When the supply of money decreases in Figure 2, the line segment AF represents a similar excess of demand for money relative to the amount in circulation. In their efforts to get more money to hold, people can cut back on their purchases of goods and services relative to their continuing income flows, or they can sell financial instruments in the bond markets. To the extent that they do the latter, the supply of bonds increases in Figure 4, pushing bond prices lower and yield rates higher. This is why the interest rates in Figures 1 and 2 rise when the demand for money increases or the supply of money decreases, respectively.
One (but not the only) source of an increase in the demand for bonds results from an excess supply of money when the demand for money decreases or the central bank increases the supply of money. Likewise, a source (but not the only one) of an increase in the supply of bonds results from an excess demand for money to hold consequent upon an increase in the demand for money or a decrease in the supply of money.
In addition to the money demand-supply relationship, the supply of bonds may also be affected by the desires of businesses to finance capital investments, the needs of governments to finance deficits or dispose of surpluses, and the intent of the central bank to execute monetary policy. Changing interest rate differentials between domestic and foreign locales may also induce bond demand or supply shifts. It is the market forces of demand and supply in the bond market which serve as the vehicle for interest rate change in the money market as noted above.
Arbitrage. Changes in the prices of bonds (and thus their yield rates) become transmitted to the prices (and yields) of other types of financial instruments via the process of arbitrage, i.e., the simultaneous purchase and sale of different types of financial instruments. Arbitrageurs are successful if they are able to operate by the criterion of “buy low, sell high.” If they are successful, they will both capture profits and precipitate convergence of prices (and yields) across the markets (a conclusion derived from the "efficient markets" hypothesis). Unsuccessful arbitrageurs will suffer losses and tend to destabilize markets, and they may cause interest rates on different types of financial instruments to diverge.
The Market for Loanable Funds
Business Demand for Loanable Funds. When business firms increase their demands for loanable funds, they increase the supply of corporate bonds coming onto the market relative to the demand for bonds, putting downward pressure on bond prices. As bond prices fall, their yield rates rise, i.e., the nominal interest rates rise. Interest rates can be expected to fall in response to a business sector decrease in the demand for loanable funds (evidence by a decrease of the supply of bonds relative to the demand for bonds, causing bond prices to rise) or if the business sector liquidates more bonds at their maturities than are being issued.
Since the demand for loanable funds is a derived demand, it must be a function of the demand for the final goods and services that can be produced with the real capital financed by the loanable funds. Nominal interest rates on long-term riskless instruments therefore cannot diverge significantly or for long from the true interest rate specified in regard to the scarcity of real capital.
Government Demand for Loanable Funds. Another source of demand for loanable funds is government. When governments at any level run budgetary deficits or otherwise mount capital spending programs that require borrowed funds (evidenced by an increasing supply of government bonds to the market), the resulting increase in the demand for loanable funds can be expected to put downward pressure on bond prices, hence upward pressure on the interest rate in the loanable funds market. Decreasing budget deficits will decrease the demand for loanable funds, and budgetary surpluses may even add to the supply of loanable funds. In either case, the interest rate will tend downward.
Consumer Demand for Loanable Funds. Consumers may also add to the demand for funds in the loanable funds market. Because "big ticket items" such as homes and motor vehicles usually cannot be purchased out of the normal flow of income, purchasers must resort to credit markets to finance them. Consumer interest rates often are higher than interest rates on funds lent for investment purposes since consumers have to bid funds away from investment uses. An increase in consumer demand for credit can thus be expected to raise interest rates in the loanable funds market.
Supply of Loanable Funds. The supply of loanable funds consists of household sector savings, undistributed corporate profits in the business sector, governments’ budgetary surpluses that are used to retire debt, and bank issued credit. When the supply of loanable funds increases relative to the demand, the nominal interest rate can be expected to fall. A decrease of the supply of loanable funds would induce nominal interest rates to rise.
The determination of the nominal interest rate in the loanable funds market is illustrated in Figures 5 and 6. In Figure 5, if the demand for loanable funds were to increase from D1 to D2, the nominal interest rate would rise from i1 to i2. The interest rate can be expected to fall from i1 to i3 in response to a decrease in the demand for loanable funds from D1 to D3.
The Fisher Effect
r = i - %?Pe.
Implicitly, if the real interest rate is known, the nominal rate can be determined by adding an allowance for the rate of inflation to the real rate.
i = r + %?Pe.
It is incumbent upon any lender to determine the nominal interest rate on a loan by adding an inflation allowance (sometimes referred to as an “inflation risk premium”) to the real rate that she/he wishes to receive after inflation has reduced the purchasing power of the funds loaned, The so-called Fisher Effect is that nominal (or market) interest rates tend to rise with increases in the rate of inflation, and to fall with decreases in the rate of inflation.
If the actual inflation rate over the term of the loan turns out to be greater than the anticipated rate, the computed real rate of inflation may turn out to be low, zero, or even negative. This is of course incongruent with the “true” interest rate concept noted above with respect to the scarcity of real capital since zero or negative “true” interest rates imply abundance or super-abundance of capital, a fact which is not in evidence anywhere in the world.
Nominal interest rates may be expected to rise with the expectation of accelerating inflation, and to fall with the expectation of deflation or a lower rate of inflation. Nominal interest rates likely will be higher in regions with higher rates of inflation, and lower in regions experiencing deflation or lower rates of inflation. Such interest rate differentials may motivate capital flows and, in turn, changes of exchange rates.
Risks, Terms, and Amounts at Loan
Interest rates may vary among different investment opportunities (including financial instruments) according to the perceived risks, the duration of investment term, and the amount at loan. As a general rule, the greater the risk, the longer the term, and the larger the amount at loan, the higher the interest rate. Lower nominal interest rates usually are applied to investment opportunities exhibiting lower risk, shorter terms, or smaller denominations. Increasing risks, lengthening terms, and increasing loan amounts will cause nominal interest rates to rise. These matters pertain more to the structure of interest rates than to determination of the level of the structure.
The Central Bank's Role
Changing financial market conditions precipitate the need or opportunity for lenders to change interest rates. However, market-determined interest rates may become “sticky” if lenders are conditioned by occasional central bank announcements of interest rate target changes. If the central bank is widely predicted or expected to announce a target rate change in the near future, lenders may wait for the announcement as the excuse or trigger for changing their actual rates. When this happens, it indeed gives the appearance that the central bank has been able to dictate a change of interest rates. But it is also true that the central bank has waited on market pressures for a rate change to build, and it is thus following the market rather than leading the market to cause rates to change.
If rates are in fact not “sticky”, once a target rate change has been announced the central bank must act behind the scenes to cause market-determined rates to approach the newly-announced target. The requisite actions are for the central bank (or its “open market committee”) to function as a bond market trader. It must enter the market to purchase bonds in order to induce bond prices to rise (yield rates to fall), or to sell bonds in order to induce bond prices to fall (yield rates to rise).
Reconciliation
In the loanable funds model, the supply of loanable funds comes principally from two sources: saving (household and business) and bank-created credit, i.e., increases of the money supply. In the money demand-supply model, an excess supply of money when the interest rate increases and becomes too high for equilibrium simply adds to the supply of loanable funds. An excess demand for money when the interest rate decreases and becomes too low would decrease the supply of loanable funds. However, changes of money demand in one country, or one central bank's changes of money supply are not the only possible influences on loanable funds in a financially open global economy. The money demand-supply model thus can provide only a partial view of interest rate determination, and it relies upon the bond market to provide the vehicle for interest rate change.
But the bond market model also feeds into the loanable funds model since any increase in the supply of bonds by businesses or government is implicitly an increase in the demand for loanable funds. However, an increase in the supply of bonds constitutes only part of any increase in the global demand for loanable funds. An increase in the demand for bonds is implicitly an increase in the supply of loanable funds, but this likewise constitutes only a part of any increase in the supply of loanable funds. The bond market theory can provide only a partial view of interest rate determination.
The Fisher Effect theory that nominal (or market) interest rates vary with the expected rate of inflation also pertains to the loanable funds model. With an increase in the inflation rate, more funds are required to finance any particular investment opportunity. A lower rate of expected inflation would diminish the demand for investment funds, allowing market interest rates to fall. Similar statements may be contrived with respect to changing risk, term, and amounts at loan.
Interest would be paid "in kind" in a barter economy. Interest is the return to scarce real capital in the same sense that the wage is the return to scarce labor. Both returns are positive as long as the respective factors of production are scarce and if they are productive. In this sense, the so-called "real rate of interest" can never become zero or negative unless the quantity of real capital becomes abundant or superabundant.
In a money-using economy, the fundamental reason that interest is paid for the use of money over some period of time is that money can be used to claim (i.e., acquire) real capital goods which increase productive capacity. The only two reasons to demand loanable funds are to use them to purchase real capital equipment and to purchase consumer goods. The reason that interest is paid on consumer loans is that loanable funds have to be bid away from purchasing real capital goods. Consumer loan interest rates often are higher than commercial loan rates simply because consumers have to out-bid business borrowers to capture some of the loanable funds.
The "real interest rate" is usually described as the nominal interest rate less the rate of inflation. The ex ante real interest rate would of course never be negative because perceptive lenders would always insist upon a contractual interest rate (nominal) which exceeds the real interest rate by enough to offset the effect of inflation to depreciate the purchasing power of the funds lent. However, if inflation is not fully anticipated, i.e., the expected inflation rate is underestimated relative to what transpires, the so-called ex post real interest rate (i.e., the nominal rate less the actual rate of inflation, after the fact) might be negative. This is incongruent with the fact that interest is a real phenomenon attributable to the scarcity of real productive capital. The "real" real interest rate can never be negative unless real capital has become superabundant.
It would be more appropriate to cease using the language of "real interest rate" to refer to the nominal rate less an allowance for inflation (expected or actual), and replace it with language about the "inflation-adjusted interest rate," which can be negative only if future inflation is not fully anticipated.
Any economy organized around markets experiences macroeconomic swings in the form of expansion and contraction of output, falling and rising unemployment levels, greater or lesser rates of inflation, and variations of interest rates, more-so for short-term rates than for long-term rates. Macroeconomic instability creates uncertainty that constrains enterprise freedom. And instability that diminishes welfare more on the downswings than it increases welfare on the upswings has the potential to limit consumer sovereignty.
After the Great Depression and World War II, the British and American governments were the first to assume responsibilities for trying to stabilize their predominantly market economies by maintaining high-enough levels of employment, i.e., low-enough levels of unemployment. Over the next half-century, these governments gradually took on responsibilities for other dimensions of macroeconomic stability, particularly the control of the price level in order to avert excessive inflation. Soon after the turn of the third millennium, the prospect of deflation became a serious concern. Governments of other countries also began to assume macroeconomic stability responsibilities.
Fiscal Policy
Possibilities for exercising macroeconomic policy lie in two broad realms, fiscal policy and monetary policy. Fiscal policy entails manipulation of the government's own budget to counterbalance swings of spending in the private sector, i.e., in the business and consumer sectors. The idea, proposed by John Maynard Keynes in The General Theory of Employment, Interest, and Money (1936), is to deliberately cause the government's budget to go into deficit (disbursements exceeding revenues) as the macroeconomy contracts. This may be accomplished by reducing taxes, increasing purchases or transfer payments, or some combination of the two. Tax cuts leave more purchasing power in the hands of taxpayers to spend, and increased government purchases and transfer payments actually inject more purchasing power into the economy. If such fiscal policy actions work as expected, the economic contraction will come to an end and the economy will begin to expand, returning production, employment, and income generation to more normal conditions.
Sometimes the turn-around from macroeconomic contraction goes too far, and the expanding economy begins to "overheat" as it approaches and exceeds its normal operating capacity. Or, quite apart from any action by government to bring about recovery from a recent downswing, the private sector of the macroeconomy may expand of its own volition (as may have happened in the US economy during the 1990s). Excessive inflationary pressures, lower than usual rates of unemployment, and plant operation above normal capacities are evidences of macroeconomic overexpansion.
When the economy over-expands, a Keynesian approach would require that the government deliberately take its budget into surplus by increasing taxes and decreasing purchases and transfer payments. These actions are intended to siphon purchasing power out of the economy so as to curb excessive spending, alleviate inflationary pressures, and bring the macroeconomy to more normal conditions of production, employment, and inflation. Of course, there is always the risk of overdoing the fiscal dampening to precipitate undesirable economic contraction.
Monetary Policy
The same risk of overdoing policy also applies to monetary policy. Monetary policy is the effort by a government’s monetary authority to determine and control the quantity money in circulation and the interest rate (the “price of money”). In most countries monetary policy is the province of a central bank, and lately there has been a growing global consensus that a nation's central bank should be as independent as possible of the political process in order to avert pressures for inflationary money supply increases as governments run budgetary deficits that have to be financed.
Monetary policy may be implemented primarily in two ways: by manipulating the interest rate or by changing the nation's money supply. Without doubt, a central bank can change its own interest rate, i.e., the one that it charges to commercial banks when they borrow from the central bank, but it is not at all clear that the central bank's changing its own lending rate causes market-determined interest rates to change. A central bank interest rate change might precipitate market interest rate changes in the same direction if banks and other lenders have been holding their lending rates constant in anticipation of a central bank rate change.
It's much more likely that market interest rates can be manipulated indirectly by the central bank with actions to change the quantity of money in circulation. The Federal Reserve Bank is the name of the central bank of the United States. The "Fed" increases the US money supply when it buys US Treasury bonds from the bond open market, paying for them with deposits to the sellers' bank accounts and additions to commercial bank reserves. Bank reserves are highly liquid assets that commercial banks, by legal requirement or banker volition, maintain in order to meet demands by depositors for withdrawals of funds. The bond sellers' increased bank deposits are additions to the money supply. When banks sell bonds, the increases of their reserves enable them to increase lending to customers, and thereby to increase the quantity of money in circulation. The Fed reduces the US money supply as it sells bonds in the open market because non-bank buyers have to pay for the bonds that they purchase by giving up some of their bank deposits, and banks that buy bonds have to give up reserves to pay for the bonds that they purchase.
The enabling conditions for the conduct of open market operations by a central bank is the existence of a large mass of public debt and an open market in which that debt is traded. But very few of the other nations' central banks are so fortunate as the US Federal Reserve in its ability to conduct open market operations to manage the US money supply. While many nations' governments chronically have run budgetary deficits, the deficits often have been financed by direct money creation (printing it) rather than issuing bonds, so there is no mass of public debt in the form of bonds and no open market in which it is traded. Some governments have financed their public debts by issuing bonds, but the bonds have been sold and are traded in open markets elsewhere in the world. There is little point in their central banks engaging in open market purchases and sales of bonds (theirs or others) in an ever more global open market because such open market transactions mostly affect money supplies in other countries or the global money supply rather than the local money supply.
Central banks that enforce reserve requirements but do not have access to the facilities of open markets in their own countries are constrained to executing monetary policy by adjusting the reserve requirement ratio that they impose on their commercial banks. This is something that the U.S. Federal Reserve is empowered by law to do, but the Fed seldom changes reserve requirements because of the potentially large and disruptive effects on the nation's money supply.
Some nations' central banks do not specify legal reserve requirements for their commercial banks to meet, leaving the determination of the amounts of such reserves to the discretion of individual commercial bankers. In these nations, monetary policy is executed by the central bank primarily in manipulating the central bank's lending rate or by engaging in open market operations.
The process of globalization with ever more-open economies, instantaneous communications, and round-the-clock bond market trading has rendered the conduct of monetary policy largely ineffectual to all but a very few central banks in the very largest economies, notably the U.S. and the E.U. It is heroic to presume that a central bank in a third-world country can significantly affect its own money supply through open market operations, reserve ratio adjustments, or central bank lending rate changes. Smaller countries are looking ever more to the U.S. Federal Reserve or the European Central Bank as the global makers of monetary policy.
To an ever-increasing extent, the money supplies of most countries are affected more by the respective government's budgetary policies and how it finances its deficits than by its central bank. Lack of fiscal discipline resulting in chronic budgetary deficits that are monetized directly by treasury departments (or indirectly by central banks under the domination of treasury departments) causes inflation--too much money chasing too few goods. This has become such a serious problem worldwide that governments of a growing number of nations are dollarizing or euroizing their currencies (or at least considering doing so). This means that they are adopting the dollar or the euro as the local currency and proceeding to replace their local currencies with dollars or euros as international trade and financial conditions permit. What they gain in dollarizing or euroizing their currencies is the monetary discipline that the US Fed or the European Central Bank exercise in restraining the growth of dollars and euros. What they lose is local control of their domestic money supplies, but it may be an illusion that they actually ever had effective control over their domestic money supplies.
Problems with Government’s Efforts to Address Macroeconomic Instability
At the middle of the twentieth century, macroeconomists thought that by engaging in fiscal and monetary policies they could fine tune a market economy to avert both cyclical swings and oscillating pressures of inflation and deflation. But experience has demonstrated in both developed and less-developed economies that government budgets are much more attuned to the requisites of program finance than to the needs of macroeconomic stability. Especially in democratic polities, legislative assemblies often perceive the need or the desire to mount new programs or enhance existing programs. But each expanded program or newly enacted program has to be financed. If financing provision is not made by way of increasing some tax or cutting back on other programs, new or expanded programs contribute to growing deficits. The deficits result in inflationary pressures if they are financed with direct money creation or if the central bank feels compelled to expand the money supply to prevent interest rates from rising (i.e., by "targeting" some interest rate). Program-oriented budget finance thus has an inherent inflationary bias.
Even if a government does attempt to manage its budget in the interest of economic stability, a growing number of economists have come to believe that deliberate fiscal actions by the government may elicit counterproductive changes in the private sector that tend to neutralize the deliberate fiscal stimulus. For example, increases of government spending to alleviate recession may increase the budget deficit, causing interest rates to rise, thus crowding out private sector borrowing to finance investment or interest-sensitive consumer spending. Or, decreases of government spending during a period of contraction may so lower market interest rates as to elicit crowding in of private sector borrowing to finance more investment or consumer spending. Both crowding-out and crowding-in effects in the private sector tend to neutralize the deliberate fiscal policy actions taken in the public sector.
Deliberate Policy Activism
During the late-twentieth and early in the twenty-first centuries, governments in a number of Western countries attempted to use monetary and fiscal policies in efforts to stabilize their economies. Experience with these efforts has convinced many economists that deliberate policy activism often involves policy overreactions due to time lags in recognizing changing conditions, initiating policy actions, and the completion of adjustments. Today, economists are not so sure that deliberate manipulation of the government's budget in efforts to diminish macroeconomic instability doesn't inject more instability into the economy than would be present if the government simply left the macroeconomy to manage itself.
Similar statements can be made with respect to monetary policy actions by the central bank that are intended to stabilize the economy, but which, because of various time lags, may tend to destabilize the economy. The financial turbulence of the Great Recession that began in 2008, together with the efforts by the U.S. and other governments to stem the recession tide, may provide an interesting test case of this proposition.
When unemployment or inflation have “reared their ugly heads,” politicians usually have felt compelled to follow the admonition, “Don’t just sit there, do something!” Because discretionary policy overreactions may tend to destabilize a macroeconomy rather than stabilize it, a growing number of macroeconomists have become discretionary policy skeptics. But politicians have difficulty following the reverse admonition: “Don’t just do something, sit there! The ability to wait patiently is simply not in the genes of political animals. Political inaction may be worse for a politician’s career than policy overreaction.
The Government's Potential for Stabilizing the Economy
When the economy experiences either an increase or a decrease of aggregate demand or a decrease of aggregate supply, there is a natural tendency for the adjustment process to return the economy to its normal operating capacity, although there may be lasting effects upon the rate of price inflation. However, the natural adjustment process takes time, perhaps extending beyond a few quarters and to several years. Belated responses or overreactions by business decision makers may set in motion cyclical oscillations that are felt with dampening effects for years, especially if managers attempt to control inventories within narrow limits. The modern industrial or post-industrial economy typically takes four or more years to complete all of the phases of a business cycle. Even though the economy possesses significant self-correcting properties, the burning questions debated by economists for decades are whether government can prevent such instability, hasten natural adjustment processes, or diminish the amplitude of oscillation.
Analyses have suggested that it is adverse changes of aggregate demand or aggregate supply that inject instability into the macroeconomy. If this is true, then it must follow that the government's best hope of eliminating or diminishing instability lies in influencing the components of aggregate demand and aggregate supply. Short of taking over the private sector by nationalizing business enterprises, the means by which the government can influence aggregate demand and supply is through its various points of contact with households and firms in the private sector. The two principal ways of doing this are to affect aggregate demand through the government's monetary and fiscal policies, and to influence aggregate supply by doing things that diminish market imperfections.
Monetary policy, the control of the money supply and interest rates, affects interest-sensitive business and consumer purchases and any consumer spending that is motivated by financial liquidity. Fiscal policy is implemented by changing the government's purchases from the private sector, or the taxes and other fees which businesses and income recipients pay to the government. Fiscal policy may also impact aggregate supply through its effects on the society's incentive structure. Various governmentally sponsored programs may be designed to facilitate the flows of information and resources, and to support or enhance incentives to work and invest.
For the moment, we shall indulge in the presumption that it is the principal objective of the government to stabilize the economy; in a subsequent section we shall consider the implications of some objective other than this. If government officials could perfectly predict private sector changes of aggregate demand or supply, they could devise offsetting changes of the government's budget which would neutralize the private sector shifts.
Fiscal Policy and Aggregate Demand. Suppose that a decrease of aggregate demand is sourced in the private sector (a collapse of investment or consumption spending) and can be perfectly predicted. In order to prevent output from falling with an attendant increase of unemployment, the government could increase its own purchases by the same amount as the decrease of aggregate demand. Or it might reduce tax collections by enough to stimulate a corresponding increase of consumption spending. The effect would be to return aggregate demand to its former level after some multiplier lag.
A private-sector sourced increase of aggregate demand, if perfectly predicted, could be neutralized by a same-magnitude decrease of government purchases or an increase of tax collections that would reduce consumption purchases by the required amount. With such perfect offsets of spending changes in the private and public sectors, inventories would not change and the macroeconomy would be stabilized.
Monetary Policy and Aggregate Demand. Monetary policy might be used to effect off-setting changes of aggregate demand. In order to counter a predicted aggregate demand decrease, the monetary authority would have to pursue an expansionary monetary policy by lowering bank reserve requirements, lowering the short-term bank rate (in the U.S., the discount rate, i.e., the interest rate charged by the central bank to commercial banks when they borrow from it), or buying bonds or other financial instruments from banks or parties in the private sector. The resulting monetary expansion, if it is not otherwise offset, results in falling interest rates to stimulate interest-sensitive expenditures and increased liquidity to stimulate liquidity-sensitive consumption purchases.
Monetary policy might offset a predicted aggregate demand increase by implementing a restrictive monetary policy, i.e., by raising bank reserve requirements, increasing the discount rate, or selling financial instruments. The ensuing monetary contraction, if it is not otherwise neutralized, will result in rising interest rates and diminishing liquidity to elicit the desired offset to the increase of aggregate demand.
Aggregate Supply Changes. Changes of aggregate supply in a market economy are even more difficult for government to offset by manipulating its own budget since it has no direct control over production capacity or cost conditions (it would have such control in a regime of socialism). It may be able to exert some influence over the long run by taking actions to make markets work more efficiently, to remove market imperfections which impede the mobility or availability of resources, to diminish reporting or compliance costs, or to remove disincentives to work or assume risks. These are all actions typically advocated in a Supply-Side approach.
It may be possible to implement a fiscal policy stimulus that will counter an adverse aggregate supply shift. Suppose that a supply shock causes the aggregate supply to decrease. The ensuing consequence is a fall of real output below the normal operating capacity accompanied by rising unemployment and cost-push inflation. If the government can be patient, it is possible that aggregate supply will recover to its earlier level after the shock has abated so that output can return to the normal operating capacity and the rate of inflation diminish. However, if this does not happen, or if it takes too long to happen, the government may implement a fiscal stimulus (i.e., increasing purchases or cutting taxes) in an attempt to increase aggregate demand. While this may hasten the return of real output to the normal operating capacity of the economy and relieve unemployment, it will likely also result in some more inflation, this time demand-pull.
Problems in the Implementation of Stabilization Policy
Unfortunately, the world does not work like this in many respects. For one, changes of government purchases or tax collections have impacts on the government's budget. If an expansionary fiscal policy causes the budget to go into deficit (i.e., expenditures in excess of revenue), the deficit must be financed. This can be done in only two fundamental ways, either by creating money or by borrowing from private sector capital markets. The former will likely cause inflationary pressures, while the latter will result in rising interest rates that may crowd-out some private sector investment, thereby offsetting the fiscal stimulus so that there is only a partial recovery. Also, there may be further changes of aggregate demand or supply to disrupt the best-laid plans to neutralize adverse demand changes.
Even if it were possible to accurately predict the magnitude of an autonomous aggregate demand or supply change, with our present knowledge and limited ability to control fiscal variables, it is highly unlikely that the right fiscal change can be implemented with any degree of precision. Thus, the fiscal measure taken would likely be either inadequate or excessive relative to the amount of autonomous change to be offset. If the government "over does it" by precipitating an excessive aggregate demand increase and there is no significant crowding-out effect, the economy may attempt to produce above its normal operating capacity with even more demand pull inflation.
It is even more difficult to use monetary policy as a means of attempting to offset private-sector changes of aggregate demand because the linkages between money-supply changes and spending are only indirect and imprecise. The monetary policy transmission mechanism works either through changing interest rates that affect interest-sensitive purchases, or through the so-called “real-balance effect” of a change in liquidity which induces consumer spending changes. At this stage of our understanding, it is not possible with any degree of precision to effect the right change of any monetary aggregate to elicit just the appropriate offsetting change of aggregate demand.
Even more troubling than these minor difficulties is the fact that it is never possible to perfectly predict changes of aggregate demand or supply, and it may not be possible to predict such changes at all. More often than not, the first evidence of a change of aggregate demand or supply becomes evident some number of months or quarters after the fact. This puts the government in the position of reacting to such changes rather than concurrently offsetting them.
Lags in the Adjustment Process
Economists refer to the time between when a macroeconomic change occurs and when it is recognized by government officials as the “recognition lag,” and the time between recognition of such a change and the taking of some action to offset it as the “response lag.” Needless to say, the lags are both variable in duration and themselves unpredictable. The response lag for monetary policy may be a matter of days or weeks, while that for fiscal policy may be months or quarters. In democratic societies, fiscal policy actions must be proposed, debated, and legislated, processes that often are very time consuming.
There is yet another lag which may eclipse the first two in duration. It is the so-called “reaction lag,” the period between when an action is taken and the effects of the action fully work through the economy. The reaction lag usually involves a multiplier process of consecutive rounds of respending. Experience in the U.S. economy suggests that the multiplier effect of a fiscal policy action may be completed in as little as a year, but may not be fully worked out in more than two years. The duration of the reaction lag is therefore even less predictable than are the recognition and response lags. The three lags together may span a period of as little as a year, or as much as three or more years. These lags taken together put the government in the position of having to implement a compensating policy even before some event shocks the economy.
This brings us to the most serious problem of implementing any government policy in the interest of stabilizing the economy. It is that the natural adjustment mechanisms of the economy will likely have reversed the direction of change of the economy by the time that the policy designed to deal with the original problem finally has its effect. For example, in a contracting economy, expansionary fiscal and monetary policies are called for. But by the time the contraction can be confirmed, expansionary policy implemented, and the multiplier process completed, the economy of its own volition will likely have begun its recovery. So the expansionary monetary policy impacts an already-expanding economy. A similar, but reversed, scenario can be depicted for an economy entering a period of expansion. Because of variable and unpredictable time lags in the implementation of macropolicy, government's well-intentioned efforts to stabilize the economy often end up destabilizing it--"booming the boom," or "depressing the depression."
A Supply-Shock Scenario
Suppose that the economy has enjoyed a modicum of stability for some number of quarters until at quarter t an unexpected supply shock occurs (for example, a foreign power embargoes an essential resource, a major proportion of which has come from the foreign source).
This precipitates a contraction for the next three quarters, but the contraction is suspected at quarter t+1 and verified at quarter t+2 when the ministry of finance submits to parliament a bill which would increase government spending to counter the rising unemployment. Parliament debates the issue until finally enacting the bill at quarter t+4. However, the natural adjustment mechanisms inherent in the economy effect a reversal at quarter t+5, after which output begins to expand and unemployment fall.
The fiscal stimulus begins to be felt by quarter t+7 as the multiplier process ensues from the injection of new spending in the economy. So, from quarters t+7 through t+10 the already-expanding economy is further buoyed by the fiscal stimulus. But by this time the ministry of finance has realized that the economy is now in expansion and inflation is threatening, so it proposes an upward adjustment of tax rates to siphon some purchasing power out of the over-expanding economy. It of course takes two more quarters of debate before the increased tax rates are enacted, and three more quarters before the negative multiplier effect begins to work, by which time the economy is already in contraction.
It is just such unhappy scenarios as that which lead many economists to become policy skeptics. Theoretically we should be able to design and implement macropolicies to stabilize an economy, but practically we do not (yet) have the knowledge or technical expertise to effectively implement such stabilizing policies.
Those who suffer from policy skepticism are not necessarily economic-stability nihilists. Many economists maintain confidence that the inherent automatic adjustment mechanisms of the market economy are sufficient to achieve stabilization naturally, if only the social and political processes can allow sufficient patience. A shocked economy will eventually "right itself," much in the same way that a listing ship will return to an "even keel" if it has adequate ballast. The ballast of the market economy consists in the automatic adjustment mechanisms in the microeconomic decision units that compose the markets of the economy. The political problem is that reliance upon the natural stabilization properties of the market economy requires that elected or appointed officials to "don't just do something, stand there" and wait patiently while the economy takes care of itself. And this is something which neither government officials seem able to do, nor their electorates tolerate.
Other Government Priorities
Finally, we must note the distinct possibility that domestic macroeconomic stabilization may not be the highest priority of the government, or at least not until the economy becomes seriously destabilized by excessive inflation or unemployment or both. Under more normal circumstances, particularly in democratic societies, the government's agenda may require it to become oriented mainly to program needs rather than economic stability. Program needs may include social, military, or infrastructure projects. A democratic government may enact such programs almost irrespective of their financing requirements.
The dominant fiscal motivation of the democratically elected government may be conducting and financing the programs to which it has become committed, irrespective of the fiscal requirements of economic stability. The principal evidence of this phenomenon is that the government's budget tends to be in chronic deficit when the economy is both contracting and expanding. When the needs of fiscal finance dominate public policy, the government loses its capacity to manipulate its budget in the pursuit of economic stability. The U.S. government finds itself precisely in this position at mid-2011.
In a flexible exchange rate world, domestic economic performance may come in at a lower priority level than attempting to stabilize the value of the nation's currency vis-a-vis one or more other currencies. Exchange rate stabilization may be accomplished with an exercise of the police power of the state to punish parties buying or selling the nation's currency at any rate other than announced "official rates." This approach, no longer in vogue in the western world, may still be used in a few "third-world" countries. In modern Western market economies, exchange rate stabilization is usually attempted by a fiscal or monetary authority intervening in the foreign exchange market to purchase the domestic currency with foreign exchange reserves in order to prevent further depreciation (or to cause it to appreciate), or to sell the domestic currency for foreign currencies in order to cause the domestic currency to depreciate (or to prevent it from appreciating). Inevitably there are side-effects of such currency purchases and sales that affect the domestic macroeconomy, often adversely. The general conclusion is that when a government is attempting to stabilize the external value of its currency, it is unable to employ macropolicy to address domestic stability concerns.
The Role of Expectations
The stability of the macroeconomy depends critically upon the expectations of decision makers concerning future macroeconomic conditions. The economy can remain stable only as long as decision makers' expectations match actual conditions fairly closely, i.e., when there are no surprises. One of the important messages of aggregate demand-supply analysis is that real output can rise above the normal operating capacity of the economy only when the actual rate of price inflation exceeds the price expectations of decision makers, i.e., when decision makers are surprised by the price inflation.
An illustration of a divergence between an actual rate of inflation and expectations of it may be occasioned by an increase of aggregate supply that would increase output beyond the normal operating capacity of the economy. Real output may fall below the normal operating capacity of the economy only when the actual rate of inflation is below decision makers' price expectations, i.e., when they are surprised by less inflation than expected. This occurs when there is a decrease of aggregate supply that takes the output of the economy below the normal operating capacity. A more general conclusion is that any ensuing period of expansion or contraction must be attributable to something unexpected which results in wrong guesses by decision makers about future conditions.
In order to make rational microeconomic decisions, the manager of a microeconomic decision unit (a business firm or a household) must be able to predict not only what is likely to happen in the macroeconomy, but also what government officials are likely to try to do about any macroeconomic problem that emerges. The first predictive problem is difficult enough; the second adds a further dimension of uncertainty. The second dimension might not be so serious except that the actions of neither monetary nor fiscal authorities turn out to be very predictable. And there are good reasons for their lack of predictability, i.e., their propensity to implement policy surprises.
Two economic theories shed light on the lack of predictability of public policy makers. The so-called “adaptive expectations hypothesis” is that intelligent decision makers learn from historical experience which they extrapolate into expectations of future states. For example, suppose that the monetary authority decides to try to increase the real output of its economy above the normal operating capacity by increasing the money supply, but it implements the expansionary monetary policy as a surprise, i.e., without making any public announcement. This action stimulates liquidity-sensitive purchases and increases aggregate demand. The demand stimulus does indeed induce an increase of output above the normal operating capacity, but it also sets in motion a process of demand-pull inflation. In a short time, consumers realize that prices are higher today than they were yesterday, and they were higher yesterday than the day before. It therefore appears reasonable to expect prices to be higher tomorrow than today, and even higher the day after tomorrow. Thus, it would be wise to go ahead and make anticipated purchases today rather than wait for the higher future prices, even if the items are not needed until a future date. The current purchases add to today's demand for those items and virtually insure rising prices tomorrow. But as noted earlier, when decision makers are surprised by the realization that prices are higher than they had counted on when they made their employment and output decisions, they will tend to adjust their employment and output plans to lower levels so that the aggregate supply decreases. This results in further inflation, but of the cost-push variety, until the economy adjusts to its normal operating capacity.
According to the so-called “rational expectations hypothesis,” decision makers reason and analyze as well as extrapolate. This view accords the decision maker the presence of mind to take into account what government policy makers might do in regard to any emerging situation, and thus to modify their behavior in response both to the situation and what the policy makers might do in response to it. Suppose that, instead of surprising the economy with a demand stimulus, the government makes public announcement that it is implementing an expansionary monetary policy with the intention of increasing the output of the economy above its normal operating capacity. Rational decision makers will deduce that an inflationary process will ensue, but they will be skeptical that the policy can sustain output above the normal operating capacity for long. Thus, when they make their employment and output decisions for the future months, they adjust their list prices and issue wage increases in anticipation of the ensuing inflation without ever increasing real output.
A comparison of the two scenarios reveals that the real output of the economy does not change, even temporarily, when the government policy is publicly announced or correctly predicted. It is only when the public policy surprises the economy or is not predictable that real output changes, however temporarily. If this theory is correct in its premise that rational decision makers analyze as well as extrapolate, then it is only by surprising the economy, or behaving unpredictably, that a government authority can have any real effect on the economy. And it is for this reason that governments tend to take unexpected policy actions and thereby interject an additional degree of instability into their economies.
The 2011 Nobel Prize in Economics was awarded to economists Thomas Sargent and Christopher Sims for their work during the 1970s and ‘80s in analyzing and modeling rational responses of society to macroeconomic changes, particularly interest rates.
Rules and Discretionary Policy
The exercise of discretionary policy is fraught with the potential for inflation, especially in response to supply shocks. For example, suppose that some natural disaster such as a massive hurricane has caused aggregate supply to decrease, setting in motion a process of contraction accompanied by cost-push inflation and rising unemployment. In order to alleviate the ensuing unemployment, government authorities will be tempted to compensate for the supply shock with an expansionary fiscal or monetary policy that will stimulate aggregate demand by enough to offset the decrease of aggregate supply. While such a policy action may stem the tide of rising unemployment, an unintended and undesired side effect will be some demand pull-inflation.
An alternative policy response by the government, and one that will avert further inflation, is to ignore the unemployment effects of the supply shock and simply wait for the economy to naturally recover and return the aggregate supply curve to its earlier level. But we can expect that most government officials would find this strategy repugnant because it requires them to "Don't just do something, stand there!" Such a response makes them appear to be either incapable or unwilling to respond to an ensuing crisis.
An even tougher policy alternative would be to greet the supply shock with a contractionary fiscal or monetary policy to cause aggregate demand to decrease. This would tend to reverse the cost-push inflation of the supply shock, but at the cost of even more unemployment. However, the recovery of the economy from the supply shock would tend to return aggregate supply to its original position with no inflationary ill effects at all. Needless to say, such a policy would likely appear to be too harsh to be politically tolerable, especially in a democracy.
Considerations such as these lead many economists to oppose the exercise of discretion by government officials, and to favor the institution of rules to govern fiscal and monetary matters. Automatic fiscal stabilizers such as progressive taxation and unemployment compensation may function in market economies to ameliorate swings in the levels of economic activity. Economists who prefer such devices over the exercise of discretionary policy may also advocate a monetary rule (or constitution). A monetary rule in the form of a formula would govern changes of monetary aggregates, and thereby remove the ability of discretionary policy makers to surprise the economy with unpredictable policy actions. While automatic fiscal stabilizers have become standard features of modern economies, government officials otherwise have been extremely reluctant to surrender their powers to exercise discretionary fiscal and monetary policies, and it appears that they will continue to be sources of instability into the foreseeable future.
The Great Recession
The so-called Great Recession began late in 2007 and worsened significantly by the end of the third quarter of 2008. It nominally ended around the middle of 2009, but output had not risen to the pre-recession level by late 2011, nor had unemployment fallen below 9 percent of the labor force. The causes of the Great Recession will continue to be debated for a long time. Our concern here is why government policy seems not to have had intended effects to alleviate the recessionary conditions, or at least not fast enough.
If economists’ understandings of macroeconomic relations are sufficient, it should be possible for government to design macropolicies to alleviate the recessionary conditions and promote a return to the normal operating capacity of the economy. Both monetary and fiscal measures were directed at the recessed conditions of the economy. The fiscal measures included both tax cuts and increased government spending, neither of which succeeded in restoring full employment. This may have been because business sector decision makers continued to suffer uncertainty about the recovery of demand conditions and the actions that government may or may not take to address the persisting high-level of unemployment.
Monetary stimulus entailed both cutting interest rates and open market purchases of bonds (“quantitative easing”). The Federal Reserve’s discount rate was set only slightly above zero. Monetary theory would suggest that serious price inflation should follow. However, some of the money supply expansion appears to have been trapped in accumulating cash hordes of business firms whose managers were reluctant to increase investing and hiring until aggregate demand first increased. Some of the monetary expansion appears trapped in the excess reserves of banks whose managers were reluctant to issue more mortgages and increase business lending, particularly to smaller businesses. The goods and services inflation rate remained low (less than 2 percent per annum). However, price increases began to appear in other sectors. Much of the expanded money supply went to commodities markets and precipitated commodities (gold, other metals, some agricultural products) price bubbles as financial market uncertainty has induced investors to seek the safety of real assets rather than financial instruments. Little of the monetary expansion reached the housing market to finance either new mortgages or refinanced mortgages.
III. Money in the Global Environment
In an open economy, the reserves of commercial banks and the money supply can be affected both by trade flows and by international capital flows. For example, if the nation experiences a favorable balance in its trade accounts (e.g., it exports more than it imports), its businesses will be receiving payments either in its domestic currency or in foreign currencies which must be converted to its domestic currency. The foreigh exchange ("forex") market is the venue for converting a foreign currency into the domestic currency, and vice-versa. An exchange rate is the price of a unit of one currency expressed in units of another currency.
During part of the twentieth century, the exchange rates of many countries' currencies were relatively stable during some periods, but more volatile during other periods. What causes exchange rates to change, and how do changing exchange rates affect macroeconomies?
Exchange Rate Determination
Under a fixed exchange regime, exchange rates are determined by government fiat. Exchange values are fixed or stabilized either by intervention of a government agency in exchange markets, or by exercise of the police power of the state to dictate official rates and punish transactions at rates other than the official rates. Under a flexible exchange regime, exchange rates are determined in foreign exchange ("forex") market by interaction of suppliers and demanders. Exchange rates vary in response to changes of demand for and supply of foreign exchange (i.e., shifts of demand and supply curves). We shall first examine the macroeconomic implications of market determination of exchange rates. Later in the chapter we shall return to the implications of governmental determination of exchange rates.
Although any exchange rate can be expressed as either the foreign currency price of the domestic currency (e.g., the euro price of a dollar, €/$) or its reciprocal, the domestic currency price of the foreign currency (e.g., the dollar price of a euro, $/€), the former should be used in order to make sense of appreciation and depreciation of the domestic currency. Figure 1 is a hypothetical illustration of the forex market for dollars priced in euros at €0.85 per dollar ($1.17 per euro) at the inception of the euro in January, 1999. In following discussion, the subscript U refers to the U.S. and the subscript E refers to Europe.
In Figure 1, the demand for the domestic currency on the forex market varies inversely with price, €/$, as its principal determinant. The demand for the domestic currency derives from two sources, citizens of the nation and foreigners. Citizens of the nation may demand their own currency on the forex market if they have acquired foreign currencies in trade, as earnings on investments, or as gifts. The foreign demand for the domestic currency is equivalent to the foreign supply of the foreign currency. Foreigners may supply their own currencies to purchase the nation's domestic currency on the forex market in order to make gifts to citizens of the nation, import goods and services from the nation, or invest in the nation.
The principal non-price determinants of the total demand (domestic and foreign) for the domestic currency on the forex market are foreign incomes, YE, foreign preferences, prefE, relative rates of inflation, PE/PU, comparative interest rates, (iU - iE), and domestic trade barriers, TariffsU, and non-tariff barriers, NTBU. This may be expressed in functional format as
(1) D$ = f (€/$ | YE, prefE, PE/PU, (iU - iE), TariffsU, NTBU),
where €/$ is the euro price of a dollar. All of the non-price determinants of demand are assumed constant (ceteris paribus) in order to specify the locus of the demand curve illustrated in Figure 1. A change of any of the non-price determinants of demand shifts the demand curve. The demand for dollars on the forex market might increase from D1 to D2 in Figure 2 if European incomes rise, European preferences for American goods improve, European price levels rise relative to the U.S. price level, or U.S. interest rates rise relative to European interest rates. The forex demand for dollars might also increase if U.S. trade barriers were to decrease.
Assuming that the supply of dollars does not change, the increased demand for dollars on the forex market induces the price of the dollar to rise. This means that the dollar appreciates relative to the value of the euro, or the euro depreciates relative to the value of the dollar. A change in any of the non-price determinants of demand in the opposite directions to those specified above would decrease the forex demand for dollars. Again, assuming that the supply of dollars does not change, the demand decrease would induce the euro price of the dollar to fall. This means that the dollar depreciates relative to the euro, or the euro appreciates relative to the dollar.
The assumption that the supply of dollars does not change is unnecessarily stringent. The same conclusion obtains in each case if the supply of dollars changes in the same direction as the demand for dollars, but by a smaller amount, or if the supply of dollars changes in the opposite direction to the change in the demand for dollars.
After the introduction of the euro on January 1, 1999, a massive flow of capital out Europe to purchase American securities and direct investments in the U.S. caused the demand for dollars to increase as Europeans supplied euros to the forex market. The demand shift and the prices shown in Figure 2 illustrate the resulting dollar appreciation from €0.85/$ ($1.17/€) at the euro inception to about €1.20/$ ($0.83/€) in late November of 2000.
In Figure 1, the supply of the domestic currency on the forex market varies directly with price, €/$, as its principal determinant. The principal non-price determinants of the domestic supply of the domestic currency to the forex market (i.e., the domestic demand for the foreign currency) are domestic incomes, YU, domestic preferences, prefU, relative rates of inflation, PU/PE, comparative interest rates, (iE - iU), and foreign trade barriers, TariffsE, and non-tariff barriers, NTBE. This may be expressed in functional format as
(1) S$ = g (€/$ | YU, prefU, PU/PE, (iE - iU), TariffsE, NTBE,
A change of any of the non-price determinants of supply would shift the supply curve. The supply of dollars to the forex market might increase, i.e., shift to the right, if U.S. incomes increase, U.S. preferences for European goods improve, the U.S. price level rises relative to European price levels, or European interest rates rise relative to U.S. interest rates. Decreases of European trade barriers also might increase the supply of dollars to the forex market. If any of these non-price determinants of supply should change in the opposite direction to those specified above, the supply of dollars to the forex market would decrease. The supply shift in Figure 3 illustrates dollar depreciation from €1.20/$ toward €1.00/$ (i.e., from $0.83/€ toward $1.00/€).
1. Short-run (i.e., within the trading day, within a trading week) changes of exchange rates are random and rarely predictable.
2. Increases/decreases in the foreign demand for the domestic currency, ceteris paribus, in the long run (over months and quarters) likely will lead to appreciation/depreciation of the domestic currency.
3. Increases/decreases in the domestic supply of the domestic currency, ceteris paribus, in the long run likely will lead to depreciation/appreciation of the domestic currency.
4. Increases/decreases of domestic incomes, ceteris paribus, in the long run will lead to depreciation/appreciation of the domestic currency. Increases/decreases of foreign incomes, ceteris paribus, in the long run likely will lead to appreciation/depreciation of the domestic currency.
5. Improving/deteriorating preferences for domestic goods, ceteris paribus, in the long run likely will lead to appreciation/depreciation of the domestic currency. Improving/deteriorating preferences for foreign goods, ceteris paribus, in the long run likely will lead to depreciation/appreciation of the domestic currency.
6. Domestic inflation at a faster/slower pace than that of foreign inflation, ceteris paribus, in the long run likely will result in depreciation/appreciation of the domestic currency.
7. Domestic interest rates which are higher/lower than foreign interest rates, ceteris paribus, in the long run likely will result in appreciation/depreciation of the domestic currency.
8. Increasing/decreasing foreign/domestic trade barriers, ceteris paribus, in the long run likely will result in appreciation/depreciation of the domestic currency.
Needless to say, any of these statements can be recast in terms of what is likely to happen to the foreign currency when any of the stipulated conditions change.
Interest Rate Parity
A cautionary note with respect to interest rate differentials is in order. Foreign interest rates that are higher than domestic rates likely will induce an outflow of funds (i.e., a capital inflow) to earn a greater interest income than possible in the domestic market. This increases the domestic supply of the domestic currency (i.e., the domestic demand for the foreign currency) on the forex market, thereby inducing depreciation of the domestic currency. However, when the principal plus interest is returned, the increased foreign demand for the domestic currency (i.e., increased foreign supply of the foreign currency) will likely induce appreciation of the domestic currency. Other things remaining the same, the net effect on the exchange rate should be approximately nil (or only slight appreciation since more funds are repatriated than originally went abroad).
Changing non-price determinants of demand or supply in the foreign exchange market may cause the domestic currency to appreciate between the time funds were sent abroad to take advantage of the higher foreign interest rate and when they are repatriated after the interest is earned. If this happens, the foreign interest rate advantage will be at least partially offset by the domestic currency appreciation since the foreign currency will now buy fewer units of the domestic currency. Should the domestic currency depreciate in the interim due to other things not remaining the same, the investor's foreign interest earnings will be augmented in the currency exchange, i.e., the investor will gain both on the interest earned and on the currency exchange since the foreign currency will now buy more units of the domestic currency. In either case, the increase in the supply of loanable funds abroad, ceteris paribus, will tend to decrease the foreign interest rate, and thereby to eliminate the foreign interest advantage.
Interest investors will continue to send funds abroad to earn higher foreign interest rates until appreciation of the domestic currency fully offsets the foreign interest advantage, i.e., until interest rate parity occurs, or until the foreign interest advantage is eliminated by the increasing supply of loanable funds relative to the demand for loanable funds abroad. The decision criterion for sending funds abroad to take advantage of higher foreign interest rates is to continue to do so as long as the foreign interest rate minus the expected percentage appreciation of the domestic currency is greater than the domestic interest rate.
Spot and Forward Exchange Rates
Spot exchange trading is for immediate (or next day) delivery. Forward exchange markets have emerged for some heavily-traded pairs of currencies. In currencies for which forward markets have emerged, it is possible to contract to purchase or sell quantities of exchange (i.e., sell or purchase the domestic currency) 30, 60, or even 90 days forward. Risk of adverse changes of exchange rates can be managed by hedging, i.e., entering into forward contracts to buy or sell quantities of exchange needed or expected in the future. Hedged positions are offsetting or covered positions. For example, a quantity of exchange may be purchased spot (the domestic currency supplied) and sold forward (the domestic currency demanded), with interest earned in the interim in a foreign market. Another example is that of a domestic exporter who ships merchandise to a foreign importer in anticipation of receipt in the foreign currency at a future date; the domestic exporter "covers" his open position by contracting for the forward sale of the quantity of exchange when its receipt is expected.
Speculators deliberately assume risk in uncovered or open positions in the forward exchange market in hopes of a favorable exchange rate change; if their predictions are right/wrong they will win/lose. Successful speculation likely will facilitate foreign exchange market adjustment toward a new equilibrium; unsuccessful speculation may destabilize foreign exchange markets.
The Demand for Money and the Demand for Exchange
It is important to note that the demand for exchange on the forex market is not coincident with the demand for money as analyzed in Chapters 10 and 11. Nor is the supply of exchange on the forex market coincident with a nation's supply of money. Only a part of the global quantity of the money supply denominated in units of a nation's currency will be offered on the global forex market at any one point in time, and only a portion of the money supply denominated in units of the nation's currency will be demanded for international transactions purposes. However, during any particular forex trading period (such as a trading day), the total volume of transactions denominated in units of a particular national currency may exceed the nominal amount of the of the nation's money supply by virtue of the fact that the same quantities may be traded many times over during the trading period.
While the demand for and supply of a nation's money are not coincident, respectively, with the demand for and supply of the domestic currency on the global forex market, they are linked by what eighteenth century economist David Hume called the price-specie flow mechanism. Hume of course was concerned with inflows and outflows of gold and silver (specie) from a nation. Modern money supplies are more diverse, consisting not only of coin and paper currencies but also of balances on deposit at financial institutions. These balances, though physically resident as liability accounting entries "on the books" of financial institutions within the nation, may be owned by foreigners as well as by citizens of the nation.
In a globally-integrated world economy, balances denominated in units of one nation's currency may have "escaped the nation" in the sense of being held as deposits at financial institutions in other nations. So-called "euro-dollars" and "petro-dollars" are examples of dollar-denominated balances held externally to the United States. Such foreign balances denominated in units of the domestic currency may have served as fractional reserves to the foreign financial institutions enabling them to create even more deposits denominated in units of the domestic currency than originally escaped the nation. The global amount of money denominated in units of a nation's domestic currency may thus have become greater than the amount issued by the central bank and financial institutions within the nation. The total amount of such money globally may not even be knowable with any degree of precision.
Deposits at financial institutions within the nation as well as domestic currency deposits residing in foreign financial institutions may be owned by citizens of the nation or by citizens of other nations. In a globally-integrated financial system, domestic interests may borrow from foreign financial institutions balances denominated in the domestic currency. In following discussion, we shall use the convention of identifying the relevant domestic money supply of a nation as those pocket currency amounts and deposit balances denominated in the currency unit of the nation that motivate the behavior of citizens of the nation, irrespective of where they reside. This concept of the relevant domestic money supply may not correspond closely to official designations of M1 or M2 since portions of either may be held by foreigners.
To add confusion to the mix, Hank Paulson, US Treasury Secretary between July 2006 and January 2009, said that official US Treasury policy favors a strong dollar, and that currency values should be determined by markets. This may appear to be a contradictory pair of statements, given the on-going dollar depreciation. But the language of "strengthening" and "weakening" of currencies as conventionally used often conveys a wrong impression.
Through much of the post World War II period the US supplied the world with dollars via foreign aid, trade deficits, foreign direct investment, and global military policing expenditures. After the failure of the Bretton Woods system in the early 1970s, the US dollar exhibited volatility but generally enjoyed sustained or appreciating exchange rates against many currencies because the world's demand for dollars seemed to increase faster than the supply until roughly the end of the twentieth century.
Around the turn of the century the world began to be satiated with dollars as the demand slowed relative to the continuing supply. Since the US Treasury persisted in its rhetoric about preferring a "strong dollar," dollar exchange rates remained high relative to real purchasing power parity ratios, and the dollar began to be perceived as "overvalued." Once this perception gained traction in currency markets and it was realized that neither the US nor any of its trading partners would intervene effectively to prevent depreciation, the dollar began to depreciate.
Why do market-determined exchange rates diverge from their real purchasing power parities? Basically, there are two reasons. One is that governments, either singly or in concert with other governments (perhaps in groups of six or seven), intervene in foreign exchange markets to cause exchange rates to move in a desired direction, or to prevent them from moving in an undesirable direction. But even without such overt government intervention, market-determined exchange rates may gradually diverge from real purchasing power parity ratios if market traders are convinced that government officials prefer a particular exchange rate level and are both willing and able to make it so. While the G7 may not have been intervening in exchange markets to any significant extent, the declared preference of the US Treasury for a "strong dollar" is likely have worked to convince market traders that dollar values should remain high even as underlying real market realities deteriorated.
The relevant question is whether an overvalued currency is a "strong" currency, and whether its depreciation toward more realistic purchasing power parity values indicates that it is "weakening"? I submit that an overvalued currency is in fact "weak" given its divergence from its real purchasing power parity and its propensity to depreciate, and that the process of depreciation toward a more realistic purchasing power parity value is indicative of the strengthening of the currency. Supporting this contention is the fact that as the dollar has continued to depreciate relative to the pound and the euro, the US trade deficit has finally begun to shrink as imports into the US have slowed and US exports have increased.
Whether a currency is "strong" or "weak" relative to another currency cannot be told by the fact that it is worth so many units of the other currency compared to historical or hoped-for future values. It is the ensuing change in the exchange rate value of a currency relative to other currencies, and assessments of prior over- or undervaluation relative to true purchasing power parities that should be considered in judging that the currency is "strengthening" or "weakening". Considered in this light, Hank Paulson’s statements that the US Treasury prefers a strong dollar and that currency values should be market determined are entirely consistent.
Does this line of thinking imply that the pound and the euro, which continue to appreciate relative to the dollar, are "strengthening"? If they have been undervalued relative to their real purchasing power parities, they have enjoyed unwarranted trade and inward investment advantages relative to currencies that are overvalued. Thus as they continue to appreciate toward their real purchasing power parity values, they in fact weaken as they surrender their advantages.
In the short run, exchange rates are volatile and virtually impossible to predict. When underlying real conditions change, market-determined exchange rates should correspond in the long run to the changing real conditions. Only when market-determined exchange rate changes accurately reflect changing purchasing power realities over the long run should an appreciating currency be described as "strengthening," or a depreciating currency be regarded as "weakening."
Suppose that an initiating change occurs in the private sector rather than by macropolicy. Starting from a situation of equilibrium in all markets, assume that the domestic demand for money to hold decreases so that there is an excess supply of money in the sense that at the current interest rate there is more money in circulation than people wish to hold.
In a similar scenario, but one for which the initiating factor occurs as a matter of macropolicy, the central bank, in an effort to implement an expansionary (or “loose”) monetary policy, increases the money supply by conducting open market purchases of treasury bonds.
The Keynesian conclusion is that people can rid themselves of their excess money balances by buying “bonds” (a Keynesian euphemism for all kinds of financial instruments) to hold in their portfolios of assets. Other things remaining the same, bond prices will rise, causing bond yields to fall.
Monetarists suggest that the bond market is not the only place where people can rid themselves of excess money balances. They may do so by increasing their consumption spending relative to the flow of their incomes so as to decrease their saving. When people increase their consumption spending, aggregate demand increases. Other things remaining the same for aggregate supply, the increased spending will induce output (and income) to increase and the price level to rise.
In a closed economy, the adjustment to an excess supply of money will be played out completely in the bond and real markets. When the economy is open to international transactions, both Current Account (goods and services) and Capital Account (bank account balances and currencies as well as portfolio investments and direct investments) responses may result as well. When there is an excess supply of money, the supply of dollars to the foreign exchange market may increase. This results in an excess supply of dollars on the foreign exchange market. This excess supply may result in a Current Account deficit (a Capital Account surplus) because the supply of dollars to buy “things” (merchandise, services, dollar-denominated bank balances, treasury bonds, stock shares, plant and equipment, etc.) from foreign sources exceeds the demand for dollars to purchase “things” domestically. The same result might have been caused by a decrease of the demand for dollars as people attempt to exchange less of the foreign currencies (i.e., to acquire fewer dollars) in the effort to eliminate the excess supply of money.
If exchange rate flexibility is permitted, a Current Account deficit causes the foreign currency (e.g., the "euro") price of the local currency (e.g., the "dollar”) to fall, i.e., the dollar depreciates, which is the same as to say that the euro appreciates. The adjustment process plays out in the form of rising domestic output and price level, increasing bond prices, and falling interest rates. The domestic adjustment process occurs just as it would in a closed economy since in a cleanly floating exchange rate system there are no international flows of reserves or changes of the domestic money supply.
But suppose that the government resolves to prevent depreciation of its currency on the forex market. One way in which to do this is to specify an official exchange rate, and then to employ the police power of the state to punish transactions at any exchange rate other than euro1. Under this type of fixed exchange regime, a Current Account deficit will persist. Imports (M) of ”things” (any type, current or capital account) exceed exports (X) of “things” with the result that the deficit (M > X) has to be paid for by an outflow of money. In David Hume’s 19th century discussion of the price-specie flow mechanism, gold would flow out in payment for the imports. In the twenty-first century, this outflow of money takes the form of foreigners acquiring ownership of domestic currency denominated bank account balances. The money outflow thus decreases the account balances of local citizens and the reserves of their commercial banks. This outflow of money and reserves has the effect of increasing the money supply. This diminishes the excess supply of money and prevents the interest rate from falling. If the outflow of money and reserves is sufficient to eliminate the excess supply of money, bond prices won’t rise, interest rates won’t fall, output won’t increase, and the price level won’t rise. This implies that in the case of a fixed exchange rate regime (like the 19th century gold standard or the 20th century Bretton Woods regime) the Current Account deficit will persist and there is no effective mechanism to relieve international disequilibria.
An alternative implementation of a fixed exchange rate regime is that a designated government agency (central bank or treasury department) enters the open market for foreign exchange when the exchange rate departs too far from the official rate (i.e., above or below specified boundaries on either side of the official rate). The exchange control authority purchases or sells foreign exchange by selling or purchasing the domestic currency.
The central bank can diminish the excess supply of dollars on the foreign exchange market by purchasing dollars, i.e., by selling euros, but its ability to do this is limited by the amount of euros in its inventory. The side effect of the sale of euros is to destroy dollar money and bank reserves. This has the effect of decreasing the domestic money supply to eliminate the excess supply of money caused by the decrease of money demand. If the central bank keeps the local currency from depreciating by selling foreign currency, no domestic changes will occur to domestic bond prices, interest rates, the output level, or the price level. The Current Account deficit persists and there is no effective mechanism to alleviate international disequilibria. Since domestic monetary policy has been dedicated to fixing the exchange rate, the central bank cannot use it to address domestic macroeconomic issues such as inflation or unemployment.
Although there is no technical limit to the ability of a central bank to supply its own currency in an effort to relieve a Current Account surplus and prevent appreciation of its own currency, the opposite possibility is severely limited. Suppose that a Current Account deficit emerges for non-monetary reasons and the prospect is for the currency to depreciate. The central bank can prevent depreciation only as long as it is able to supply the foreign currency to the foreign exchange market in buying back its own currency (thereby reducing the domestic money supply and the reserves of domestic commercial banks). Once the central bank stocks out of the foreign currency, it can no longer prevent depreciation of its currency. Depreciation ensues until the Current Account deficit is alleviated. Experience during the post-Bretton Woods era (since 1972) suggests that central banks, singly or in coordination with other central banks, rarely have the will or enough foreign exchange reserves to fully alleviate Current Account deficits.
A nominally flexible exchange rate regime has been in place since the early 1970s. Under a flexible exchange regime international adjustment to changing international circumstances is automatic (though not necessarily immediate as claimed by some writers). The exchange rate falls until an emerging Current Account deficit is eliminated. This means that the domestic adjustment to an incipient Current Account deficit is increase of domestic output, prices, and employment, just as would occur in a closed economy. Of course, these increases may be prevented by exercise of contractionary macropolicy. Unlike a fixed exchange rate regime in which monetary policy must be dedicated to keeping the exchange rate fixed, under a flexible exchange rate regime monetary policy is free to be applied to domestic macropolicy problems.
Current Account Deficits and the Domestic Money Supply
The possible causes of an emerging or growing Current Account deficit (i.e., a Capital Account surplus) of a nation are the same things that cause depreciation of its domestic currency on foreign exchange markets. Three of the most prominent causes are domestic incomes increasing at a faster pace than foreign incomes, domestic inflation at a faster pace than foreign inflation rates, and domestic interest rates which are lower than foreign interest rates. The domestic inflation rate and domestic interest rates of course vary with changes of the domestic money supply.
An emerging or growing Current Account deficit is likely to increase the supply of domestic money to the forex market (i.e., increase the demand for the foreign currency). Assuming that the demand for domestic money has not changed, the resulting excess supply likely will induce depreciation of the domestic currency on the forex market. The depreciation of the domestic currency makes the nation's exportables look cheaper to foreigners and imports from abroad appear more expensive to citizens, thereby alleviating the Current Account deficit.
How forex market transactions affect the domestic money supply of a nation depends upon the identities of the purchasers and sellers of the exchange. With a Current Account deficit, one source of the increased supply of the domestic currency to the forex market is foreigners who have acquired the domestic currency as export earnings, as income from investments in the nation, or as unilateral transfers (gifts) from citizens or the government of the nation. If foreigners supply quantities of the domestic currency to other foreigners through the forex market, the relevant domestic money supply (that which motivates the behavior of citizens of the nation) does not change.
Another source of the increased supply of domestic currency to the forex market is efforts by citizens of the nation to convert quantities of the domestic currency into foreign currencies in order to purchase imports from foreign sources, to invest overseas, or make unilateral transfer (gifts) to foreigners. To the extent that foreign interests acquire money balances denominated in units of the domestic currency from citizens of the nation, the nation's relevant domestic money supply (that which motivates the behavior of citizens of the nation) decreases. Assuming that the domestic demand for money does not change, the domestic money supply decrease may result in falling domestic prices, rising domestic interest rates, and decreasing employment. The falling domestic prices of tradeables tend to increase the volume of exports and reduce the volume of imports. The rising domestic interest rates tend to decrease the volume of investment by citizens in other countries and increase the volume of investment by foreigners in the nation. The decreasing domestic employment decreases incomes in the nation and thus curbs imports.
One view is that the burden of adjustment borne by domestic prices, interest rates, and employment is lessened by the currency depreciation. Another view is that these three phenomena supplement the depreciation of the domestic currency in alleviating the Current Account deficit. But if depreciation of the domestic currency is prevented by government authorities who are resolved to "defend the currency" from further "weakening," the full burden of adjustment to the Current Account deficit will descend upon domestic prices, interest rates, and employment.
Some of the domestic money that is supplied to the forex market may be acquired by citizens of the nation who wish to convert foreign currency denominated export earnings, investment income, or gifts from foreigners into the domestic currency for repatriation. Such currency transactions between citizens of the same nation do not affect the domestic money supply, even though they pass through the forex market. Such citizen-to-citizen forex market transactions may bulk large enough relative to the volume of transactions between citizens and foreigners that the reduction of the domestic money supply consequent upon a Current Account deficit will itself be diminished. Although the usual presumption is that the domestic money supply decreases, if the volume of citizen-to-citizen or foreigner-to-foreigner transactions in the domestic currency is large enough, the domestic money supply may be little affected by a Current Account deficit. In this case, the domestic macroeconomic adjustment will be minimal and the correction of the imbalance will depend largely upon depreciation of the currency if the government will let it ensue.
The depressive macroeconomic effects of a decrease of the relevant domestic money supply in response to a Current Account deficit may motivate the government of the nation to attempt to neutralize (or sterilize) the monetary contraction with off-setting purchases of bonds in the domestic open market. If domestic macroeconomic contraction is prevented, the full burden of adjustment to the Current Account deficit must fall upon exchange rate depreciation. If the government also resolves to prevent its currency from depreciating by intervening in forex market to purchase quantities of the domestic currency, no mechanism of adjustment is allowed to function, and the Current Account deficit may persist indefinitely. It may be inferred that a fixed exchange rate system (like the Gold Standard or the Bretton Woods system) is fundamentally incompatible with the exercise of modern macroeconomic policy designed to stabilize the domestic economy.
This section has explored the effects of a Current Account deficit (i.e., a Capital Account surplus) that increases the supply of a nation’s domestic money to the global forex market and causes its exchange rate to depreciate. The reader is invited to reread this section, making appropriate modifications for a Current Account surplus that decreases the supply of the domestic currency to the global forex market.
Exchange Rate Policy and Monetary Policy
The central bank may passively allow the net effects on the domestic money supply to have the natural price and interest rate effects, or it may attempt to neutralize the impact on the domestic money supply with off-setting monetary actions in the open markets for financial instruments in the nation.
Under a nominally flexible exchange rate regime, monetary authorities may at times attempt to influence the direction of exchange rate change by purchasing other currencies (i.e., supplying the domestic currency) to induce depreciation or prevent appreciation of the domestic currency. Or they may sell other currencies (i.e., demand the domestic currency) to induce appreciation or prevent depreciation of the domestic currency. When they do either they may forego the ability to exert monetary policy in pursuit of domestic goals. When authorities attempt to manipulate flexible exchange rates, the regime may be described as a "dirty float".
In a fixed exchange rate regime (such as the Gold Standard or the Bretton Woods System), the principal responsibility of the monetary authority becomes the control of the exchange rate within narrow tolerances of a target rate. In such a situation, monetary policy cannot be directed toward domestic problems, and the "tail wags the dog," i.e., the interest of the domestic economy is made subsidiary to the need to stabilize the exchange rate.
Macroeconomic Adjustment to International Disturbances
As the world economy becomes progressively more open and economically integrated, the vehicles for macroeconomic adjustment to internationally-sourced disturbances attain ever greater significance. Basically, there are only three macroeconomic adjustment vehicles: exchange rates, domestic prices (including interest rates), and domestic employment (and incomes). A progression of "if statements" identifies the relevant adjustment possibilities:
1. If exchange rates are allowed sufficient flexibility, they may serve as "shock absorbers" for the domestic economy against internationally-sourced disturbances.
2. If exchange rates are fixed by government authorities, domestic prices and incomes assume the burden of adjustment.
3. If domestic prices are insufficiently flexible, the adjustment process must descend upon domestic employment and incomes.
4. If government authorities employ macropolicy to stabilize domestic prices and incomes, exchange rate flexibility must serve as the adjustment vehicle.
5. If government authorities attempt both to stabilize domestic prices and employment and to fix exchange rates, there is no effective vehicle of macroeconomic adjustment to international disturbances. In the absence of an effective adjustment vehicle, payments imbalances will persist.
An important conclusion emerges from these considerations: the degree of domestic macroeconomic stability of a nation may depend upon the degree of flexibility that its government accords to rates of exchange between its currency and other currencies. As a general rule, we may expect domestic macroeconomic conditions in any economy to be more volatile in response to international disturbances the less flexible are its exchange rates. Fixing or stabilizing exchange rates forces the adjustment to international disturbances upon domestic macroeconomic conditions of prices and employment.
The Insulation Properties of Exchange Rate Regimes
Can exchange rate flexibility insulate the domestic economy from international disturbances? Suppose that there has occurred an externally-sourced (foreign) decrease of demand for domestically produced "things" (anything, including merchandise, services, financial instruments, direct investments, etc.). If this decreased demand impacts primarily the current account (merchandise and services), the result is a decrease of exports (X). The resulting decrease of the demand for dollars on the foreign exchange market to purchase such things precipitates an incipient balance of payments (BoP) deficit and portends a depreciation of the exchange rate.
While our objective is to consider the insulating properties of exchange rate flexibility relative to foreign disturbances, we should note that the same incipient BoP deficit and exchange rate depreciation pressure would result from an internally-sourced increase of the demand for foreign-made things which increases the supply of dollars to the forex market. If the increased demand for foreign things impacts primarily the current account, the result is an increase of imports (M).
In either case, net exports (X-M) decrease, causing a decrease of aggregate demand. To the extent that aggregate demand decreases, real output falls and unemployment rises.
Under a flexible exchange rate regime, if depreciation occurs concurrently with the decreased demand for exports or increased demand for imports, the lower foreign price of the domestic currency makes domestic goods appear cheaper to foreigners and foreign-made goods appear more expensive to domestic consumers. Both effects offset the decrease of aggregate demand, and ideally will prevent any net decrease. In this best-case scenario, the exchange rate depreciation serves to insulate the domestic economy completely from the effects of decreased demand for domestically produced things or the effects of increased domestic demand for foreign-made things. Output doesn't fall and unemployment doesn't rise.
Exchange rates respond to a variety of influences other than what is happening in the current account, and they often respond sluggishly to changing international conditions. If the exchange rate falls too slowly or doesn't fall far enough to prevent a net decrease of aggregate demand, output and employment may fall, at least temporarily. In such less-than-ideal scenarios, exchange rate flexibility may not be sufficient to completely insulate the domestic economy from foreign disturbances.
A deliberate policy to cause a nation's currency to depreciate may be intended to stimulate the economy by increasing exports. However, even as a depreciating currency lowers the delivered foreign-currency prices of the nation's exports, it raises the domestic-currency prices of the nation's imports. As the depreciating currency makes the delivered foreign-currency prices of the nation's exports appear lower to foreign importers, domestic exporters may raise the domestic-currency prices of their export goods to cover the higher-cost imported content. The net effect is to offset or neutralize the stimulative effect of the currency depreciation. The offsetting effect is larger the greater is the import content of the exported goods. The offsetting effect diminishes the shock-absorber property of exchange rate flexibility.
In contrast, under a fixed exchange rate regime there is virtual certainty that international disturbances will impact the domestic economy. How they do so depends critically upon the strengths of secondary effects. One way in which exchange rates may be fixed is for government to specify an official exchange rate, and then to employ the police power of the state to punish transactions at any exchange rate other than the official rate. With an overvalued currency that cannot depreciate, increasing imports or decreasing exports cause a growing current account deficit that decreases aggregate demand. Output and income fall and unemployment rises.
Secondary effects may ameliorate the contraction. Consequent upon the falling incomes, the demand for money decreases, causing an excess supply of money at the current interest rate. In the Keynesian transmission mechanism, the excess supply of money causes the demand for bonds to increase, raising bond prices and depressing interest rates. As interest rates fall, interest-sensitive consumer and business investment spending increase. In the monetarist transmission mechanism, some to the excess money supply goes directly to consumption spending, irrespective of interest rates. In either case, the increased spending causes aggregate demand to recover, thereby ameliorating the initial contraction.
But other secondary effects may dampen the amelioration. The emerging BoP deficit has to be paid for by an outflow of money, represented by the excess supply of dollars to the forex market. In David Hume’s 19th century discussion of the price-specie flow mechanism, gold would flow out in payment for the imports. In the 21st century, the money outflow usually is accomplished by foreigners acquiring ownership of dollar-denominated bank balances in payment for the excess of imports over exports. The money outflow decreases the account balances of local citizens and the reserves of their commercial banks. This outflow of money and reserves has the effect of decreasing the money supply. This diminishes the excess supply of money and may prevent the interest rate from falling. If the outflow of money and reserves is sufficient to eliminate the excess supply of money, bond prices won’t rise, interest rates won’t fall, output won’t increase, and the price level won’t rise. This implies that when exchange rates are fixed, an international disturbance is likely to have adverse impact on the domestic economy when all of the secondary effects are taken into account. This also implies that in the case of a fixed exchange rate regime (like the 19th century gold standard or the 20th century Bretton Woods regime) the BoP deficit will persist and there is no effective mechanism to relieve international disequilibria.
In the more liberal (market oriented) implementation of a fixed exchange rate regime, a designated government agency (central bank or treasury department) enters the open market for foreign exchange when the exchange rate departs too far from the official rate (i.e., above or below specified boundaries on either side of the official rate). The exchange control authority purchases or sells foreign exchange by selling or purchasing the domestic currency. The net exports decrease also decreases aggregate demand. Output and income falls, and unemployment rises. As income falls, the demand for money decreases. In the foreign exchange market the excess supply of dollars can be eliminated by a central bank purchase of dollars by selling enough foreign currency. This amounts to an open market sale in the foreign exchange market, the side effect of which is to destroy money and bank reserves. This has the effect of decreasing the money supply to eliminate the excess supply of money caused by the decrease of money demand. If the central bank keeps the local currency from depreciating by selling foreign currency, the domestic economy is likely to be impacted adversely by the external disturbance. As long as the BoP deficit persists, there is no effective mechanism to alleviate international disequilibria. And, since domestic monetary policy has been dedicated to fixing the exchange rate, the central bank cannot use it to address domestic macroeconomic issues such as inflation or unemployment.
Unfortunately, there is a severe limit to the ability of a central bank to prevent depreciation of its own currency. It can prevent depreciation only as long as it is able to supply the foreign currency to the foreign exchange market in buying back its own currency (thereby reducing the domestic money supply and the reserves of domestic commercial banks). Once the central bank stocks out of the foreign currency, it can no longer prevent depreciation of its currency. Depreciation ensues until the BoP deficit is alleviated. Experience during the post-Bretton Woods era (since 1972) suggests that central banks, singly or in coordination with other central banks, rarely have the will or enough foreign exchange reserves to fully alleviate BoP deficits.
The Gold Standard
A nationalistic sort of policy emerged in the second half of the nineteenth century as many of the industrializing nations of Europe and North America resolved to eliminate volatility in the exchange rates among their currencies by establishing metallic standards. While the United States flirted with gold and silver bimetallism, it along with most other nation states settled upon gold as standard by the end of the century. Subscription by a nation to the Gold Standard was accomplished by having some government exchange-control authority, usually the treasury or a state sponsored bank or central bank, to maintain the value of the currency in terms of gold at an established (by fiat) ratio between a unit of the currency and an ounce of gold.
Maintenance of the so-called "mint parity ratio" of the currency to gold was accomplished in most nations by commissioning the designated authority to engage in open market purchases and sales of gold. Arbitrarily established upper and lower bounds were set around the mint parity ratio by each authority. When the nation's currency began to depreciate relative to gold, i.e., when the market value of an ounce of gold in terms of the currency unit threatened to rise above the upper bound, the authority would sell enough gold (by buying enough of its own currency in the market) to keep the value of its currency from rising above the upper bound. Or if the currency began to appreciate relative to gold, i.e., when the market value of gold in terms of the currency unit threatened to fall below the lower bound, the authority would buy enough gold (by selling enough of its own currency in the market) to keep the value of its currency from falling below the lower bound.
Some of the more authoritarian states have attempted to stay on the Gold Standard by employing the police power of the state to keep the currency value fixed to the mint parity ratio. This was accomplished by governmental issuance of edicts establishing the "official" or legal exchange rate. Anyone caught buying or selling the currency at any rate other than the official rate would suffer sanctions ranging from rather innocuous fines through incarceration to various forms of capital punishment such as being hanged, beheaded, or shot by firing squad. Such exercise of the police power of the state served only to suppress the effects of payments imbalances, which persisted and worsened in the absence of an adjustment mechanism.
In the majority of nations that relied upon market intervention rather than police power to keep their currency values fixed to gold, the ability to prevent depreciation or appreciation of their currencies was asymmetrical. The ability to avoid depreciation depended critically upon the exchange control authority's accumulated gold reserves. Once the authority "stocked out" of gold in its efforts to prevent the currency from depreciating, its currency would depreciate. On the other hand, there was no limit to the ability of an exchange control authority to prevent its currency from appreciating since the government could always create (print) more of its own currency without limit in order to purchase ever more gold from the market. Of course, the side effect of the effort to prevent appreciation of the currency was the potential for inflation.
It may be argued whether currency value stabilization under the Gold Standard is micro- or macropolicy. Since the object of the policy is to stabilize a price (the value of a unit of the currency relative to an ounce of gold), it certainly is a microeconomic matter. But variation or fixity of this single price causes macroeconomic consequences by affecting the volumes of imports and exports of all goods entering into the nation’s trade with other nations.
By the early years of the twentieth century, international economists had become aware of what became known as the "Gold Standard rules of the game". There are two of them, each a corollary of the other. The first is that under the gold standard, countries suffering trade deficits should relieve their payments problems by allowing or causing their economies to contract (decreasing output, rising unemployment, falling incomes) and deflating their prices. These conditions would have the effect of curbing imports and stimulating exports so as to relieve the trade deficit.
The second of the "Gold Standard rules of the game" is that countries enjoying trade surpluses should allow or cause their economies to expand (increasing output, falling unemployment, rising incomes) and inflate their prices. These conditions would have the effect of stimulating imports and curbing exports so as to relieve the trade surplus.
Two crucial, ultimately fatal (to the Gold Standard), problems emerged in regard to the Gold Standard rules of the game. First, response turned out to be asymmetrical. Because the effort to keep their currency values fixed to gold led to a hemorrhage of their gold reserves, trade deficit countries were compelled to contract and deflate their domestic economies. But trade surplus countries felt no similar compulsion to expand and inflate their economies as their gold reserves accumulated. Second, with the advent of modern macropolicy following Keynes' publication of his General Theory, governments became ever less tolerant of domestic economic contraction or price inflation, and with the newly identified tools of fiscal and monetary policy they could act to prevent either. Efforts both to fix exchange rates and to insulate domestic economies from variations in incomes, employment, and prices left the world without an international adjustment mechanism.
This second matter sounded the death knell for the Gold Standard. The Gold Standard was suspended at the outbreak of "The Great War" (also known as "World War I"), reinstituted tenuously during the 1920s, and finally ended by massive capital flights in 1933 during the Great Depression. A new general principle emerged: fixed exchange rates are fundamentally incompatible with macropolicy intended to stabilize the domestic economy. A corollary to this principle is that nations which commit to fix their exchange rates surrender ability to apply macropolicy to domestic economic conditions. As a consequence, their domestic economies tend to be more unstable (higher unemployment rates, higher inflation rates, and greater variation of each) than do nations whose governments allow exchange rate flexibility. The verity of this corollary has been born out during the post-World War II era under the pseudo-gold standard known as the Bretton Woods System. It can also be seen more recently among those European countries that have fixed their exchanges rates in the run up to the activation of the new currency, the euro.
The Bretton Woods Regime
After World War II, representatives of the governments of the victorious Allied nations met in Bretton Woods, New Hampshire, to hammer out a new exchange rate regime. While it had become obvious that the Gold Standard was unworkable in a world of discretionary policy, there was lingering sentiment favoring a metallic monetary standard as a means of minimizing exchange risk. The system devised at Bretton Woods constituted the U.S. dollar as the central reserve currency and gave U.S. monetary authorities the responsibility to keep the value of the dollar fixed to gold at $35 per ounce. Other nations subscribing to the Bretton Woods system would then stabilize their currency values to the dollar. In this way, the risks associated with varying exchange rates would be eliminated, or at least minimized.
During the era of the Bretton Woods exchange rate regime (after World War II until 1971), official reserves (foreign currency stocks and gold) were used by the governments attempting to fix the exchange rates between their currencies and the U.S. dollar. Governments of nations suffering payments deficits (Current Account deficits not fully offset by Capital Account surpluses) prevented their currencies from depreciating by entering the exchange markets to purchase their own currencies with gold and foreign currencies possessed by them. The persisting disequilibria between Current and Capital Account balance totals elicited changes in domestic incomes, employment levels, and price levels since exchange rates could not change to accomplish the needed adjustments to international phenomena.
In order to slow the depletion of their gold and foreign currency reserves, governments of nations suffering payments deficits occasionally devalued their overvalued currencies. This was accomplished by devaluing their currencies relative to the dollar, or by officially increasing the mint parity ratios (number of units of currency per ounce of gold) at which they would buy and sell gold. Governments stocking out of gold or foreign currencies could no longer continue to keep their currencies from depreciating. Governments of nations enjoying payments surpluses felt little compulsion to revalue their currencies upward, and they could easily prevent their currencies from appreciating relative to gold or other currencies since they could create (or print) more of their own currencies to purchase gold or foreign currencies.
During the 1960s the U.S. was faced with persisting BoP deficits which caused continuing depletion of its gold and foreign currency stocks as it attempted to keep the dollar-gold exchange rate fixed as required by the Bretton Woods regime. The Nixon administration in the U.S. finally suspended disbursements of gold to foreign interests in August of 1971. This marked the end of the Bretton Woods system and the beginning of the present era of floating exchange rates.
The Post-Bretton Woods Era
From the end of the Bretton Woods era in 1971 until the present, the global exchange rate system has nominally been one of flexible or floating exchange rates. However, governments, singly or in small ad hoc groupings (e.g., the Group of 7), have entered foreign exchange markets in efforts to manipulate one or another exchange rate. Sometimes the objective has been to arrest the decline or rise of an exchange rate. Occasionally it has been to try to push an exchange rate in a desired direction.
After the passage of the Maastricht Treaty in 1991, eleven (of the fifteen) nations of the European Union resolved to establish a common currency, the euro, by the turn of the millennium in the so-called euro-zone. The intent was to establish the euro as an accounting unit by January 1, 1999, and to replace the national currencies of the euro-zone nations with euros by January 1, 2002. In the run up to the change-over, each national currency was first stabilized in value to the euro within narrow bounds (+/- 2.5 percent) of a central rate, and then fixed in an absolute sense to the euro with no allowed stabilization zone.
Since 2002 the euro experienced both depreciation and appreciation relative to the dollar, but overall it enjoyed substantial success until the global financial collapse of the so-called Great Recession beginning in 2008. The increasing budget deficits and cumulating public debts of several southern European nations (Greece, Spain, Portugal, Italy) have posed a challenge to the survival of the euro since the affected nations are not able to devalue their currencies under the euro common currency regime.
Money creation and monetary policy to control it are vested in the Federal Reserve (the US central bank established by Act of Congress in 1913) that is tasked with the dual responsibilities of maintaining price stability and promoting stable economic conditions (low-enough rates of unemployment, and fast-enough rates of economic growth). Discretionary policy enthusiasts maintain that over the course of the twentieth century, with the exception of the “Great Depression” of the 1930s decade, the centralized monetary and fiscal policy capabilities of the US federal government agencies have been reasonably successful in ameliorating the magnitudes of economic swings and limiting their durations. The exigencies of the “Great Recession” of 2008-10 have shaken faith in the capabilities of the Federal Reserve and the Treasury Department to maintain economic stability of the US economy.
The privileged position occupied by the dollar in the post-WWII era has enabled monetary policy implemented by the Federal Reserve to have global impact. Some other countries that have been unable to muster sufficient fiscal and monetary discipline to avert inflation have yielded monetary control to the Federal Reserve by “dollarizing” their currencies. Dollarization has occurred either by official government action (Argentina), or informally as their populations have preferred to use and receive dollars in commercial and foreign investment transactions. The enabling condition for a nation to dollarize its currency is to run sufficient Current Account surpluses (or Capital Account deficits) to allow replacing its domestic currency with dollars.
The dollar’s privileged position has also enabled the US Department of Treasury to finance US government budget deficits year-after-year by continually issuing ever more Treasury bonds that are desired to be held as “safe assets” by parties around the world, including governments of other countries. Excessive issuance of US Treasury bonds may in the future result in skepticism of the ability of the US government to redeem them, and thus to diminish their desirability if the quantity supplied of them begins to exceed the quantity demanded.
Since the turn of the third millennium, the euro has also attained a similar (but lesser) privileged position, and the monetary policy implemented by its issuer, the ECB, is also having global effects. A growing proportion of world trade is being denominated in euros instead of dollars. And, a few countries outside of the European Union either have “euroized” their currencies or are contemplating doing so.
Over the past two centuries, monies have undergone a momentous transformation so that today there is very little commodity money still in use anywhere in the world. Now, virtually all modern monies are debt (or credit) monies in the forms of token coins, promise-to-pay paper currencies (which are liabilities of governments), and checkable deposits (which are liabilities of commercial banks). The reason that this has been such a momentous transformation is that now there is technically no limit on the amounts of such debt monies that can be brought into existence by governments and central banks. Therein lies the importance of central banks to national and global economic stability.
The U.S. Federal Reserve
The central bank of the United States is the Federal Reserve System. It is a "decentralized central bank" in that it consists of twelve regional banks that are governed by a common governing board, the Board of Governors of the Federal Reserve System. The seven governors each serve fourteen-year terms, and are appointed to the Board by the President of the United States. The terms are phased so that one seat comes up for appointment every two years. Thus, during a four-year presidential term, a sitting president can appoint two members to the Federal Reserve Board of Governors, and perhaps more than two if some of the sitting members resign, retire, or die in office. If the president is reelected to a second term, he or she would then have opportunity to appoint four of the seven members of the Board.
Appointments to the central bank governing board are very important in the U.S. and in other nations with strong, independent central banking institutions (e.g., to the European Central Bank). Federal Reserve governors are considered by some to be no less important in the U.S. economy than are the presidential appointments to the Supreme Court. A sitting president with two terms can "stack" both the Supreme Court and the Federal Reserve Board with members who are ideologically compatible with the administration, and thereby leave an ideological legacy well into the next president's term of office. The reason that appointments to the Federal Reserve Board are so important is that the Board can affect (some say "control") the amount of money in circulation in the economy.
Pursuant to fostering stability in the economic and financial systems, a mission of the U.S. Federal Reserve is to ensure a stable money supply that is sufficiently flexible to meet seasonal needs, and which grows fast enough to meet the needs of a growing economy, but not so fast as to contribute to inflation. Over the decades since the founding of the Federal Reserve in 1913, its monetary policy role has expanded to manipulation of the U.S. money supply in efforts to precipitate desired changes in levels of employment, prices, and interest rates, or or to offset actual or expected undesirable changes in these economic dimensions.
Monetary Policy Tools
Courses in macroeconomics generally focus on two types of macropolicy: fiscal policy and monetary policy. With respect to monetary policy, such courses survey the "tools" or "weapons" which can be used by the central bank of an economy to affect the volume of commercial bank reserves, and indirectly the amount of money in circulation. Such discussions then are extended to the macroeconomic implications of monetary expansion or contraction. These devices and consequences presume an unspoken assumption of a closed economy, i.e., an economy not open international trade or capital flows.
In a closed economy that uses exclusively debt money (i.e., without the possibility of fortuitous increases in the quantities of commodity monies or digital monies such as "Bitcoin"), a central bank that is the monopoly provider of the debt money can exert near perfect control of the domestic money supply. It can therefore play a dominant role in stabilizing the economy. This might be achieved by allowing or causing the money supply to increase steadily by just enough to accommodate the needs of the growing domestic economy. More importantly, economic stability is served by not allowing the money supply to exhibit significant variations in its rate of growth.
Three principal quantitative monetary policy tools are at the disposal of the Federal Reserve Board in the United States: reserve ratio adjustment, discount rate adjustment, and open market operations. The first is relatively insignificant in the U.S. economy. Since the early 1970s, the Federal Reserve has changed reserve ratio requirements only to effect structural adjustments, probably on the view that policy changes would have drastic consequences for the banking system and hence for macroeconomic stability.
The Discount Rate and Capital Scarcity
The discount rate is the interest rate that commercial banks pay for the use of reserves borrowed from the Federal Reserve itself, but it is an administered price rather than a market-determined price. Although there seems to be a current presumption among monetary policy makers that the discount rate is the preeminent policy tool, it is not at all clear that discount rate changes also cause market-determined interest rates to change.
Economists conventionally identify four “factors of production”, land, labor, capital, and entrepreneurship, and the so-called returns to them, respectively, rent, wage, interest, and profit. Since interest is the return to real capital (real productive capacity, e.g., plant, equipment, housing), the "true" interest rate in any region is a measure of the scarcity of capital in the region relative to the demand for it. This true (or scarcity) interest rate is higher in regions where capital is scarce and lower in regions where capital is more abundant. The true interest rate should fall as capital becomes more abundant, e.g., with on-going economic development. It would rise if capital were to become scarcer, e.g., when equipment is destroyed by a natural disaster or if gross investment in the region should become less than depreciation so that the capital stock actually shrinks.
In a financial sense, interest may be defined as the price for the use of a dollar’s (or other local currency unit's) worth of credit for a year. The issuance or sale of a financial instrument by a business firm or a government agency is an implicit demand for credit. The prices of financial instruments are determined by the interaction between forces of demand for and supply of them in the loanable funds market. Yield rates on financial instruments are understood to be their interest rates, computed from information about their market prices. Yield rates, which vary inversely with the market prices of financial instruments, also may vary by risk factors and terms to maturity.
When business firms increase their demands for loanable funds, they increase the supply of corporate bonds coming onto the market relative to the demand for bonds, putting downward pressure on bond prices. As bond prices fall, their yield rates rise, i.e., their bond interest rates rise. Bond interest rates can be expected to fall in response to a business sector decrease in the demand for loanable funds (evidenced by a decrease of the supply of bonds relative to the demand for bonds, causing bond prices to rise) or if the business sector retires more bonds at their maturities than are being issued.
The demand for loanable funds is a derived demand that is a function of the demand for the final goods and services that can be produced with the real capital financed by the loanable funds. Yield rates on long-term riskless financial instruments therefore cannot diverge significantly or for long from the true interest rate determined by the scarcity of real capital relative to the demand for it.
It may be a delusion to think that a central bank by changing its discount rate can cause market-determined interest rates to change very much from the scarcity rate of return on real capital. When a central bank changes its discount rate, it might precipitate changes of market interest rates in the same direction if banks and other lenders have been holding their lending rates constant in anticipation of a central bank rate change. But allowing for risk and term differences, market interest rates are determined ultimately by the scarcity of real capital relative to the demand for it.
Monetary Policy Actions
The Fed may be proactive in changing its discount rate (an administered price) with the intention of drawing (or dragging) market-determined interest rates along with it. For example, if Fed officials perceive the need to pursue a stimulative policy, it might lower the discount rate (unless it is already at or too close to zero), thereby reducing a positive spread or creating or widening a negative spread between the discount rate and the Federal Funds rate (a market-determined rate). Commercial banks, finding it cheaper to borrow reserves from the Fed than from other commercial banks at the Federal Funds rate, can both increase lending and offer lower lending rates to commercial borrowers. If commercial enterprises now borrow more from their banks and issue fewer bonds, the supply of bonds will decrease relative to bond demand, bond prices will rise and bond yield rates will fall. If this chain of events has occurred, the decrease of the discount rate has induced market-determined yield rates to fall, thereby stimulating economic activity.
Of course, as noted by Keynes, "There are many a slip twixt the cup and the lip." If the discount rate is already very low, there may not be room to further decrease it without taking it to zero or into the negative realm (where the Fed would be paying commercial banks to borrow from it). Or, if commercial banks already are holding excess reserves relative to reserve requirements, the lower discount rate may not induce them to borrow more reserves from the Fed. Or, if commercial bankers feel the need to hold even more in excess reserves, they may not increase lending. Or, if commercial enterprises see few opportunities for profitable investment, they may not increase borrowing, even if offered lower lending rates. If any of these conditions obtain, the decrease of the discount rate will not have its intended effect on market-determined interest rates.
The reader now is invited to recycle through the previous two paragraphs while considering a need perceived by Fed officials to pursue a contractionary monetary policy.
Upon occasion the Federal Reserve has changed the discount rate after the fact of changes in market-determined rates. This may happen when Fed officials perceive that the spread between the discount rate and the Federal Funds Rate has become too wide. When this happens, the Federal Reserve is following the market to get its administered-price interest rate in line with market realities rather than leading it and determining market interest rates.
When central bank monetary policy actions are unpredictable, markets for goods and services as well as for stocks and bonds may wait breathlessly to see whether the central bank is going to try to cause market interest rates to change, in what direction, or by what magnitude. Market traders who prognosticate the central bank's policy changes may take preemptive actions to offset what they think that the central bank might do. If their guesses are right, they may render the central bank's actions impotent. Wrong guesses by Fed prognosticators are likely to aggravate whatever problem the economy is experiencing. A surprise monetary policy action or a failure by a central bank to act when expected also can disrupt the stability of the economy.
If a central bank is unable to directly affect market interest rates by changing its discount rate (or if the discount rate is already so low that further decreases would take it to zero or into the negative range), it may try to use the third monetary policy tool, open market operations (a.k.a., "quantitative easing" or tightening). In this regard, the Federal Reserve Board of the United States has a luxury available only to a small number of central banks around the world. By virtue of the existence of a large volume of public debt (U.S. government treasury bonds) for which an extensive open market has developed, the Federal Reserve can trade in this market to buy and sell government securities. The side effect of such trading is to affect the reserves of commercial banks and either indirectly or directly the quantity of debt money in circulation in the economy.
There are more than 160 national central banks in the world (http://centralbank.monnaie.me/). In a small nation with only a rudimentary local open market for its government securities, open market operations can be far less effective. The central bank of such a nation may not be able to engage in effective open market operations to affect the reserves of its domestic commercial banks if government deficits have been financed for the most part by direct monetary expansion rather than public bond offerings. Even if the the central bank should opt to purchase or sell bonds in other bond markets (e.g., the London, New York, or Tokyo bond markets), it would affect the reserves of commercial banks and the money supplies in other nations more-so than in its own nation. In such cases, monetary policy must rely upon reserve ratio and discount rate adjustments.
The Open Economy World
In the case of a large nation with an open economy, monetary policy is likely to be even less effective. In an open economy, the reserves of commercial banks and the money supply can be affected both by trade flows and by international capital flows. For example, if the nation experiences a favorable balance in its trade accounts (e.g., it exports more than it imports), its businesses will be receiving payments either in its domestic currency or in foreign currencies which must be converted to its domestic currency, and the effect necessarily is to expand the domestic money supply, whether the central bank wants it to expand or not. Monetary contraction would necessarily follow from trade deficits. International capital flows motivated by international interest rate, inflation rate, and income change differentials would also be expected to affect the domestic money supply, irrespective of the wishes of the central bank.
In an open economy world, the chief occupation of the central bank may become off-setting or neutralizing the domestic monetary effects of trade and capital flows so that targets may be pursued with respect to some domestic monetary aggregate. However, if the central bank in fact does this, it renders inoperable the natural adjustment mechanisms which would correct trade and capital flow imbalances. The consequence is continuing depreciation or appreciation of the nation's exchange rate vis-a-vis the currencies of other nations. Exchange rate changes may buy time to allow the nation to correct fundamental imbalances by adjusting its domestic prices and incomes, but if the central bank is neutralizing the effects of trade and capital flows on the domestic money supply, these fundamental adjustments may never occur.
The central banks of some nations occasionally take their mission to be stabilization of the nation's exchange rate, usually to prevent further depreciation. The nation's exchange rate probably has been depreciating because the nation is experiencing deficit in its trade balance. To prevent further depreciation, the central bank must purchase its own currency from the exchange rate markets by selling its holdings of other currencies (or gold). The side effect of this is to take money out of circulation, which results in contraction of income and output in the domestic economy (because money held by the central bank is not part of the money supply). This is the medicine which is necessary to correct the conditions that led to the currency depreciation pressures.
Upon occasion the U.S. Federal Reserve has participated with the Treasury Department in efforts to stabilize the dollar (provide "orderly conditions") on foreign exchange markets. There have also been instances when the effort has been directed toward forcing further depreciation of the dollar in order to relieve trade deficits, and other instances when the effort has been to support the value of the dollar by preventing further depreciation. In the former case, the Federal Reserve has been in the market to sell dollars (buy other currencies); in the latter case it buys dollars (sells other currencies). Its ability to prevent further depreciation of the dollar is the extent of its holdings of other currencies and gold.
When a central bank chooses the mission of exchange rate stabilization, the so-called "Gold Standard Rules of the Game" come into play. If the currency of the deficit nation is not allowed to depreciate, then its domestic economy must experience deflation of prices and contraction of its real income and output. When macropolicy is oriented toward exchange rate stability, "the tail wags the dog" in the sense that the domestic economy has to adjust to international circumstances. In this case, domestic monetary policy must force domestic economic contraction of income and employment in order to keep the exchange rate from depreciating. Currency blocs typically do not survive for long because their governments reach the conclusion that it is better to suffer exchange rate depreciation than domestic income and output contraction.
Relevant Money Supplies
It is conventional to designate money supply definitions by the capital letter "M" plus a number ranging from 0 through 3 or 4, depending on the relative degree of liquidity of the items contained in the definition. The behavioral relevance of a money supply definition is what monetary items actually motivate spending by citizens and residents of the nation. On this consideration, perhaps the most widely accepted definition of a nation's money supply is M2 which includes coin, currency, checkable deposits, and small denomination savings and time deposits that are easily converted into any of the other monetary types included in M2. Most central banks include in the M2 statistics that they compile those items denominated only in units of their own currency, e.g., the "dollar" in the United States.
In an open-economy world it is possible that monetary balances denominated in several currency units will motivate spending by a nation's citizens and residents, irrespective of whether the balances are held domestically or abroad. A critical behavioral question is whether the relevant money supply of the nation should include monetary balances held abroad by citizens, and citizens' monetary balances denominated in currency units other than the nation's own money, irrespective of where they are held. For example, do American holdings of Turkish lira influence the spending habits of American consumers and businesses? The answer is perhaps not much because the Turkish lira is one of the world's minor currencies, and not a large quantity of them have escaped the Turkish economy to be held by Americans.
Let's put the question from the perspective of Turkish citizens: do Turkish holdings of American dollars in Turkey or elsewhere influence the spending habits of Turkish consumers and businesses? There may be more reason to respond in the affirmative to this question because the dollar is one of the world's international reserve currencies, and a very large volume of dollars has escaped the United States to be owned by people in other nations. If the answer is yes, then this implies that dollar holdings by Turks should be included in the Turkish money supply along with Turkish lira and other currencies which affect Turkish spending decisions. The relevant money supply for any nation, including both the U.S. and Turkey, is not purely its own domestic currency, but all of those things which can serve as media of exchange by its citizens anywhere in the open-economy world.
A large volume of dollars has escaped ownership by Americans in the post-WWII era due to the Marshall Plan, American tourism, imports of foreign merchandise and services, foreign direct and indirect investment by American firms, foreign aid disbursements, and continuing American military presence and spending in other nations. These foreign-owned dollar balances have become known as Eurodollars, Petrodollars, Asiadollars (or other regional specifications) depending upon the national identity of the holders. The quantities of such foreign dollar holdings have become far larger than the original quantities spent or transferred overseas by virtue of the fractional reserve nature of banking on a world-wide scale. Although foreign bankers holding dollars are not subject to the Federal Reserve's reserve ratio requirements, they do choose to hold reserves against their dollar deposits as a matter of prudence. But their excess reserves of dollars yield no income, so they may issue dollar-denominated loans, just as American banks do, thereby creating additional dollar money. The successive rounds of redepositing and relending result in multiple credit creation, in this case of dollar money supplies held outside of the United States. So while we can know with some precision the dollar deposits in American banks within the U.S. economy, it is not possible to know with any degree of precision at all how much dollar money there is in the whole world.
Global Currency
What does this mean for control of the U.S. money supply by the Federal Reserve? It is perhaps heroic to think that the Federal Reserve Board of governors can effectively control the money supply that is relevant to spending behavior in the U.S. economy. It is also heroic to think that in an open-economy world any nation's central bank can neutralize the monetary effects of international trade and capital flows with any degree of precision in order to allow pursuit of domestic monetary growth targets. Dollar balances are functioning extensively as a third-party currency in facilitating both trade and financial transactions. By virtue of the large volume of dollars in use in the world, the dollar is has become a de facto world currency. Americans may borrow Eurodollars, Petrodollars, or Asiadollars for spending and investment in the U.S. economy or anywhere else in the world. This means that the dollar-denominated domestic M2 money supply, which is the usual target of Federal Reserve monetary policy, is a fiction, or is at least an inadequate target. In order to effectively exercise monetary policy to stabilize the U.S. economy, the Fed should target not just the global M2 dollar money supply, but also aggregates of any and all currencies held by Americans and foreigners anywhere in the world which might be spent in the U.S. economy. Now we are talking about a truly heroic scale of monetary policy. And we are also talking about the exercise of monetary policy by one of the world's central banks on a scale that can affect economic conditions in other nations of the world.
There are several (but not so many) currencies in the world, the control of which by some central bank may be instrumental in economic stabilization. We can mention in addition to the U.S. dollar, the euro, the Chinese yuan, and the Japanese yen. When the central banks of any of these nations or regions set out to exercise monetary policy, even in respect only to their own currencies or only the quantities in their own economies, they may have important macroeconomic consequences for other economies of the world, and they may not achieve the intended effects in their own economies. This is why it is important to global economic stability for there to be coordination among the central banks. Indeed, the Group of Seven (G7) finance ministers have made a start in this direction, but they are not central bankers, and they have usually coordinated efforts to control exchange rates rather than monetary policy more broadly.
Leaving aside the question of whether central bank monetary manipulation may have unintended deleterious effects, would it be more efficient in an open world economy to have a single central bank which coherently administers monetary policy in the interest of world economic stability? Would this be a super-national central banking institution, or could it be simply one of the extant central banks which emerges to exercise de facto world-scope central banking prerogatives, whether recognized or accepted by other nations and central banks or not? I can think of only a couple of candidates in this regard: the U.S. Federal Reserve or possibly the European Central Bank. And what if the emergent de facto world central bank fails to recognize its world role, but mistakenly continues to exercise monetary policy in regard to its small but significant corner of the world?
These are questions to which answers are not clear, but with which the world needs to wrestle. Monetary conditions are too important not to be addressed.
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